[Senate Hearing 109-890]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-890

 
                           THE DEVELOPMENT OF
                       NEW BASEL CAPITAL ACCORDS

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

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                                   ON

PLANS OF THE U.S. BANKING AGENCIES TO UPDATE AND ENHANCE THE REGULATORY 
CAPITAL PROGRAM THROUGH IMPLEMENTATION OF THE INTERNATIONAL CONVERGENCE 
  OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS, AND REVISIONS TO THE 
        EXISTING DOMESTIC RISK-BASED CAPITAL FRAMEWORK FOR BANKS

                               __________

                           NOVEMBER 10, 2005

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html

                                 ______

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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                         Mark Oesterle, Counsel

                         Andrew Olmem, Counsel

                  Aaron D. Klein, Democratic Economist

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                      THURSDAY, NOVEMBER 10, 2005

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................    12
    Senator Hagel................................................    13

                               WITNESSES

John C. Dugan, Comptroller of the Currency, U.S. Office of the 
  Comptroller of the Currency....................................     2
    Prepared statement...........................................    39
Susan Schmidt Bies, Governor, Board of Governors of the Federal 
  Reserve System.................................................     4
    Prepared statement...........................................    45
    Response to written questions of Senator Shelby..............    95
Donald E. Powell, Chairman, Federal Deposit Insurance Corporation     6
    Prepared statement...........................................    50
    Response to written questions of Senator Shelby..............   119
John M. Reich, Director, Office of Thrift Supervision............     7
    Prepared statement...........................................    66
    Response to written questions of Senator Shelby..............   133
L. William Seidman, Former Chairman, Federal Deposit Insurance 
  Corporation and Former Chairman, Resolution Trust Corporation..    21
    Prepared statement...........................................    72
William M. Isaac, Former Chairman, Federal Deposit Insurance 
  Corporation and Chairman, The Secura Group.....................    22
    Prepared statement...........................................    73
George G. Kaufman, Co-Chair, U.S. Shadow Financial Regulatory 
  Committee and John F. Smith Professor of Finance and Economics 
  Loyola University Chicago......................................    25
    Prepared statement...........................................    76
Daniel K. Tarullo, Professor, Georgetown University Law Center...    27
    Prepared statement...........................................    85
Katherine G. Wyatt, Head, Financial Services Research Unit, New 
  York State Banking Department..................................    29
    Prepared statement...........................................    91

                                 (iii)


                           THE DEVELOPMENT OF
                       NEW BASEL CAPITAL ACCORDS

                              ----------                              


                      THURSDAY, NOVEMBER 10, 2005

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 9:30 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order. You can 
tell we generally start around 10:00, but some people will have 
to leave here today, and I want to put you on notice that we 
have stacked votes starting about 11:30, so maybe we can 
accelerate the hearing and not lose any substance.
    Today's hearing will examine recent developments regarding 
the new Basel Capital Accord known as Basel II and certainly 
proposed revisions to existing U.S. capital requirements known 
as Basel I-A. Federal banking regulators have recently made two 
important announcements with regard to Basel II. First, on 
September 30, Federal banking regulators announced their 
revised plan for implementing Basel II. Under the revised plan, 
the implementation will begin in January 2008 with a parallel 
trial run followed by a 3-year transition period from 2009 to 
2011.
    Because Basel II will require banks to maintain complex and 
costly internal risk assessment processes, Federal banking 
regulators have said that Basel II will apply to only the 
largest, most sophisticated banks. Just a few days after 
banking regulators announced the revised Basel II timetable, 
they announced proposing revisions to existing capital 
requirements, which have been referred to as Basel I-A.
    The purpose of Basel I-A, as I understand it, is to 
modernize the capital requirements for the roughly 7,000 or so 
banks that do not qualify for Basel II. Additionally, Basel I-A 
aims to address concerns that the application of Basel II to 
only the largest banks would create a bifurcated capital 
requirements system that could put small and regional banks at 
a competitive disadvantage.
    It is my hope that today's hearing will shed additional 
light on the implications of adopting Basel II and the new 
Basel I-A. The changes to U.S. capital requirements proposed by 
Basel II and Basel I-A will have far-reaching implications on 
not only the safety and soundness of the U.S. banking system 
but also on both the competitiveness of the U.S. banking 
industry and the effectiveness of Federal banking regulators.
    Before we implement any changes, I believe we need to make 
sure that we fully understand these implications.
    Today's hearing will have two panels. Our first panel 
includes John Dugan, Comptroller of the Currency; Governor 
Susan Schmidt Bies of the Federal Reserve Board of Governors; 
Chairman Donald Powell of the Federal Deposit Insurance 
Corporation; and Director John Reich of the Office of Thrift 
Supervision.
    Our second panel will follow them and will include Mr. 
William M. Isaac, former Chairman of the FDIC and Chairman of 
Secura Group LLC; Professor George Kaufman, Co-Chair of the 
Shadow Financial Regulatory Committee and the John F. Smith, 
Jr. Professor of Finance and Economics at Loyola University 
Chicago School of Business Administration; Mr. William Seidman, 
no stranger to this Committee, former Chairman of the FDIC, 
former Chairman of the Resolution Trust Corporation and CNBC 
Chief Commentator; Professor Daniel Tarullo, Professor of Law, 
Georgetown University Law Center; and Ms. Katherine Wyatt, Head 
of the Financial Services Research Unit, New York State 
Banking.
    We welcome all of the witnesses to today's hearing. Without 
objection, your written testimony will be made part of the 
record in its entirety, and Mr. Dugan, we will start with you. 
Sum up your testimony.

                   STATEMENT OF JOHN C. DUGAN

                  COMPTROLLER OF THE CURRENCY,

         U.S. OFFICE OF THE COMPTROLLER OF THE CURRENCY

    Comptroller Dugan. Thank you, Chairman Shelby. I appreciate 
this opportunity to discuss the plans of the U.S. banking 
agencies to strengthen regulatory capital requirements for our 
banking system. We intend to do this in two fundamental ways: 
First, through implementation for our largest banks of the 
framework generally known as Basel II, and second, for banks 
not adopting Basel II, through revisions to our capital rules 
in an initiative generally known as Basel I-A.
    In both efforts, our primary goal is to substantially 
strengthen the long-term safety and soundness of our banking 
system. Our largest banks require a more risk-sensitive 
regulatory capital system to address their complex operations 
and activities. For banks not adopting Basel II, we need to 
increase the risk sensitivity of risk-based capital without 
unduly increasing regulatory burden.
    To ensure that Basel II would be consistent with continued 
safety and soundness, the U.S. agencies conducted a 
quantitative impact study earlier this year known as QIS-4. As 
you will hear in more detail today, the QIS-4 results, which 
were based on crude approximations of Basel II requirements, 
nevertheless raised real concerns among the agencies because 
they forecast substantial reductions in capital for Basel II 
banks and substantial differences in capital requirements for 
very similar credits.
    Because these preliminary results would be unacceptable if 
produced by the final Basel II framework, the agencies 
conducted in-depth discussions about QIS-4 and what that should 
mean for the future of the Basel II process. The result of 
these discussions was an agreement by all the agencies to move 
forward but only with substantial new safeguards to address the 
QIS-4 concerns.
    This agreement, which was released as a joint statement on 
September 30, was based on several key premises. First and 
foremost, despite the preliminary forecasts of QIS-4, the Basel 
II framework provides necessary improvements to address 
recognized flaws in the existing risk-based capital regime for 
our largest, most complex banks. Basel II will promote 
significant advances in risk management that will benefit 
supervisors and banks alike and substantially enhance safety 
and soundness.
    Second, apart from the notice and comment process, further 
study of the Basel II framework itself will do little to 
resolve concerns raised by QIS-4, which by necessity was based 
only on preliminary approximations of a completed Basel II 
system. Instead, we need to observe live systems in operation--
and subject them to rigorous supervisory scrutiny--before we 
will be able to rely on Basel II for regulatory capital 
purposes.
    And third, we must proceed deliberately, gaining a better 
understanding of the effects of Basel II on bank risk 
management practices and capital levels. That means a 
meaningful transition period during which we can scrutinize 
Basel II systems while strictly limiting potential reductions 
in capital requirements through a system of simple and 
conservative capital floors. Based on the experience we gained 
through supervisory oversight in the transition period, we will 
incorporate any necessary revisions to Basel II before the 
transition period ends. I believe that once the Basel II 
framework is implemented completely and rigorously supervised 
in the controlled environment of the transition period, and 
once we have had the opportunity to make necessary changes to 
the framework based on the knowledge we gain during that 
period, the concerns raised by QIS-4 will be addressed.
    While the comprehensive Basel II framework is necessary and 
appropriate to address the complex risks of our largest banks, 
it would be far too burdensome and expensive to impose on our 
other banks. Instead, we need meaningful but simpler 
improvements to our capital rules for these banks that would, 
first, make capital more sensitive to risk, and second, address 
competitive disparities raised by the Basel II changes for our 
largest banks. That is the purpose of our Basel I-A initiative, 
in which the modifications we are considering would increase 
the number of risk-weight categories, expand the use of 
external credit ratings, and employ other techniques to 
increase the risk sensitivity of capital requirements.
    The banking agencies agreed that it is critical to have 
overlapping comment periods next year for the rulemakings on 
both Basel II and Basel I-A. This will allow the industry to 
compare the proposals as they prepare their comments, and will 
allow us, as regulators, to take both sets of comments into 
account in finalizing each proposal--a process that will allow 
a better assessment of the potential competitive effects of 
these proposals on the U.S. financial services industry.
    To summarize, doing nothing to revise our capital rules 
would, over time, threaten the safety and soundness of the 
banking system, especially with regard to our largest banks 
that engage in increasingly complex transactions and hold 
increasingly complex 
assets. Basel II provides a conceptually sound and prudent way 
forward for these largest banks by more closely aligning 
regulatory capital and risk management systems with actual 
risk. Likewise, Basel I-A will provide a more risk sensitive 
framework for non-Basel II institutions.
    Although both processes will take time and will inevitably 
change to address supervisory concerns, I believe they both 
will substantially enhance safety and soundness. It is for this 
essential reason, safety and soundness, that I believe we 
should support the approach embodied in proposals for Basel II 
and Basel I-A.
    Thank you very much.
    Chairman Shelby. Thank you very much, Mr. Dugan.
    Governor Bies on behalf of the Fed.

           STATEMENT OF SUSAN SCHMIDT BIES, GOVERNOR,

        BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Ms. Bies. Thank you, Mr. Chairman.
    I appreciate the opportunity to join my colleagues from the 
other Federal banking agencies to discuss the current status of 
Basel II in this country as well as the status of our proposed 
amendments to our existing Basel I risk-based capital rules. 
The Federal Reserve considers the maintenance of strong and 
stable financial markets to be an integral part of our 
responsibility and criticality 
related to the safety and soundness of the participants in 
those markets.
    Part of maintaining a strong financial system is to ensure 
that banking organizations operate in a safe and sound manner 
with adequate capital cushions that appropriately support the 
risks taken. There have been two major developments in the past 
6 weeks regarding U.S. regulatory capital requirements that 
apply to banking institutions: One relating to the Basel II 
framework and another to the proposed Basel I amendments.
    The Federal Reserve considers the ongoing discussion 
between the Congress and the U.S. banking agencies--and of 
course with the banking industry and members of the public--to 
be critical to the success of both sets of proposals. While the 
current Basel I-based rules have served us well for nearly two 
decades, they are no longer appropriate for identifying and 
measuring the risks of our largest, most complex banking 
organizations.
    The Basel II framework is designed to improve supervisors' 
ability to understand and monitor the risk-taking and capital 
adequacy of these institutions. It should also provide market 
participants with a better ability to evaluate the risk 
positions at those institutions. And perhaps most importantly, 
Basel II should enhance risk management at institutions 
adopting it. The advanced approaches under Basel II offer 
particularly good improvements in terms of risk sensitivity, 
since those approaches incorporate risk management processes 
already used by certain banks today.
    In April of this year, the agencies announced jointly their 
reaction to initial results of a fourth quantitative impact 
study pertaining to Basel II known as QIS-4. The initial QIS-4 
results prompted the agencies to delay issuance of a notice of 
proposed rulemaking (NPR) for Basel II in order to conduct 
further analysis of those results and their potential impact. 
During the summer, the U.S. agencies jointly conducted 
additional analysis of the information reported in QIS-4 and 
collectively decided to move ahead with an NPR but adjusted the 
plan for U.S. implementation of Basel II by extending the 
timeline and by augmenting the transitional floors.
    Probably the most important thing we learned from the QIS-4 
analysis is that progress is being made toward developing a 
risk-sensitive capital system. From QIS-4, we also learned that 
the favorable point in the business cycle from which the 
measurement was conducted had an effect on minimum regulatory 
capital produced; that the dispersion was largely due to 
varying risk parameters used by different institutions; and 
some of the data submitted by individual institutions, as 
expected, was not complete.
    Based on the results of QIS-4, the Federal Reserve 
recognizes that all institutions have additional work to do. 
Indeed, QIS-4 should not be considered a complete forecast of 
Basel II's ultimate effects, since it was a point-in-time look 
at how the U.S. implementation was progressing. We certainly 
expect that as we move closer to implementation, supervisory 
oversight of the Basel II implementation methodologies would 
increase. In fact, we would not allow any bank to move to 
transitional floors until we are satisfied that their Basel II 
process met our standards.
    The proposal for the Basel I amendments, an advance notice 
of proposed rulemaking, relates, in part, to some longstanding 
issues in our current capital rules. It is also intended to 
mitigate certain competitive inequalities that may arise from 
the implementation of Basel II. In considering these possible 
revisions, the U.S. agencies are seeking to enhance the 
relationship between inherent risks in bank portfolios and 
minimum regulatory capital without undue complexity or 
regulatory burden on the Basel I banks.
    For both Basel II and Basel I amendments, the Federal 
Reserve fully supports the retention of the existing prompt 
corrective action regime, which the Congress put in place more 
than a decade ago, as well as supporting existing leverage 
requirements. These regulations help to ensure a minimum level 
of capital both at individual institutions and in the 
aggregate, which we consider to be absolutely vital to the 
health of our financial system and economy.
    We look forward to continuing to engage the industry, the 
Congress, fellow supervisors, and others in discussion about 
what effects the Basel II framework and the Basel I revisions 
might have on our banking system. We will remain vigilant about 
potential unintended and undesired consequences. We will make 
adjustments as necessary to ensure that minimum regulatory 
capital reflects risk exposures at individual banks and is 
adequate for the safety and soundness of the banking system.
    Finally, I would like to emphasize that from my 
perspective, the U.S. agencies have worked well with one 
another on these regulatory capital proposals, and worked in a 
general environment of cooperation and good will, and we expect 
that will continue. I thank my colleagues at the other agencies 
for their efforts in developing the U.S. proposals for Basel II 
and Basel I amendments.
    Thank you, Mr. Chairman.
    Chairman Shelby. Chairman Powell.

                 STATEMENT OF DONALD E. POWELL

        CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION

    Chairman Powell. Good morning, Mr. Chairman. Thank you for 
holding this important hearing.
    Recently, the agencies described a plan for moving forward 
with Basel II in the United States. Basel II has the potential 
to bring about positive change for U.S. capital regulation and 
that is why I participated in, and support, the agency plan.
    Basel II will require better risk management for adopting 
banks and give the agencies better data to identify emerging 
risks. Basel II will give banks more flexibility on risk-based 
capital. For Basel II banks whose risk-based capital 
requirements exceed leverage ratio requirements, there even is 
a potential for a moderate reduction in overall capital 
requirements. The FDIC can and does support these things.
    I would like to focus on the interaction of the Basel II 
framework and our U.S. leverage ratio for bank regulatory 
capital. There are other important issues, of course. Should 
capital requirements for mortgages be reduced 90 percent or 
more as Basel II permits? Do capital requirements for credit 
card lending need to be increased by 66 percent on average? How 
can we get consistency in capital requirements under Basel II? 
What about the competitive impact on smaller institutions?
    Those questions are important, but none are so fundamental 
to the long-term cost of our Federal banking safety net as how 
Basel II interacts with the leverage ratio.
    QIS-4 supports earlier FDIC analysis showing that Basel II 
is a much lower numerical capital standard than we have in 
place today. For most insured banks, QIS-4 would require tier 
one capital-to-asset ratios that are far less than what would 
be allowed under current prompt corrective action regulations.
    As we ask what to make of these QIS-4 results, it is 
important to remember that the current Basel II framework is 
not a scientifically pure method for measuring bank capital 
needs but an imperfect framework crafted to reach consensus 
among Basel Committee members. The U.S. banking system is among 
the most well-capitalized in the world, and it is no surprise 
that an internationally acceptable capital standard might not 
be consistent with U.S. capitalization levels.
    Putting aside these international comparisons, let me be 
clear that the FDIC views the extremely low capital numbers 
coming out of Basel II formulas as evidence that changes must 
be necessary going forward. We view the QIS-4 results as 
examples of why, under Basel II, the leverage ratio will play a 
more important role than ever in ensuring the soundness of our 
banking system.
    I believe my colleagues at the table share our discomfort 
with the low levels of capital indicated by QIS-4 results. They 
have noted that the leverage ratio would rightly prevent banks 
from lowering their capital that much. They also share our hope 
that experience in the Basel II transition years would help us 
pinpoint and correct the aspects of the framework that give 
rise to troubling QIS-4 results.
    Yet, beyond those hopes for the future, there is a great 
conflict of expectations that is going to have to be better 
understood and resolved. The agencies' plan allows banks to 
reduce their risk-based capital requirements over 3 years by 5 
percent, then 10 percent, then 15 percent, after which there is 
no floor or risk-based capital requirements.
    This phase-out of floors dangles the prospect before banks 
of much lower overall capital requirements. Yet, most banks in 
the QIS-4 would continue to have overall capital requirements 
determined by the 5 percent leverage ratio. Therefore, any bank 
that thinks Basel II will not be worth the effort without the 
elimination or significant reduction in the leverage ratio 
needs to make its views known.
    With the PCA standards in place since the early 1990's, 
U.S. banks have faced more conservative capital regulations 
than most of their international competitors. This same time 
period has been one of historic profitability for large U.S. 
banks, and I do not believe they are suffering under a 
disadvantage.
    There can be little doubt, however, that with Basel II 
requiring half or less the core capital as does our current 5 
percent leverage standard for many insured banks, Members of 
Congress will hear from our industry about overly conservative 
regulators and the competitiveness of large U.S. banks.
    Those are fundamental questions that cannot be answered by 
looking at the output of a formula. They will require a 
different kind of policy debate than we have had so far about 
the scope of the Federal safety net and the role of bank 
capital in international competition. Since Basel II was never 
advertised as an effort to reduce capital systemwide, 
discussions of the new framework have never revolved around 
those issues.
    The regulators today appear generally of one mind about the 
future of bank capital regulation in the United States and on 
this basis have agreed to proceed with Basel II. As I have said 
today, there is more work to be done. I hope and believe the 
future leaders of the agencies will continue to insist on the 
best of both worlds: Sophisticated bank risk management and a 
clear-cut minimum of regulatory capital to protect against 
future banking crises. Thank you.
    Chairman Shelby. Thank you, Chairman Powell.
    Mr. Reich.

                   STATEMENT OF JOHN M. REICH

             DIRECTOR, OFFICE OF THRIFT SUPERVISION

    Director Reich. Thank you, Chairman Shelby and Senator 
Hagel. I appreciate the opportunity to be here today to present 
views similar to that which you have heard expressed, the views 
of the Office of Thrift Supervision on the development of the 
Basel II capital framework in the United States along with the 
parallel modernization of current risk-based capital standards 
under Basel I.
    We are more than 2 years from the start of a proposed 4-
year phase-in of Basel II. There are significant hurdles to 
overcome before we can represent to you, Mr. Chairman, that it 
will be ready to be implemented on a permanent basis. Some 
suggest that Basel II is not necessary; that we simply need to 
update our existing capital rules to accommodate advances and 
changes in the banking system since the 1988 Basel I Capital 
Accord. We are reviewing our current rules, but it is important 
for us to work with all of our institutions to determine what 
is most important and appropriate for them.
    For the largest and most sophisticated banks and especially 
those that operate internationally, Basel II may be the most 
appropriate capital framework. For other institutions, either 
the current Basel I rules or a modified Basel I framework may 
be most appropriate.
    In an advance notice of proposed rulemaking issued last 
month, we raised this issue, and we welcomed comments on the 
ANPR to guide us on how best to update our existing Basel I 
rules, including whether the status quo should be retained as 
an option. OTS supports the goals and objectives of Basel II, 
and we are committed to implementing a more risk sensitive 
capital framework for all of our regulated institutions.
    While it is important that the United States continue to 
move forward on Basel II, we should proceed in a cautious, 
well-studied and deliberate manner. The revised timeframe for 
Basel II is consistent with this goal. However, it is critical 
that all interested parties, including the industry, the 
Congress, and the regulators, that we continue an active, open, 
and thorough dialogue regarding Basel II. We will continue to 
work with Members of this Committee, the other Federal banking 
agencies and with our international colleagues on these issues.
    Perhaps the most significant challenge that we face in this 
process is maintaining competitiveness. While Basel II provides 
an opportunity for our largest U.S. institutions to move to a 
more logical, risk-based capital framework and to remain 
competitive internationally, it is equally important to 
identify ways to improve the risk sensitivity of existing Basel 
I rules.
    These objectives are not mutually exclusive but rather 
mutually dependent in order to prevent potential competitive 
inequities between Basel II and Basel I institutions. OTS is 
pleased that Basel I modernization, an initiative that we have 
advocated, has evolved into a commitment by all of the Federal 
banking agencies. The goal of this initiative is to achieve 
greater risk sensitivity without undue complexity.
    We strongly support finding ways to improve existing Basel 
I rules in conjunction with the implementation of Basel II if 
not sooner. The results of the QIS-4 study suggested that Basel 
II remains a work in progress in the United States. Consistent 
with this message, the Federal banking agencies recently 
announced a 1-year delay in the start of Basel II and an 
additional phase-in year for its implementation. We also 
provide for greater supervisory control over individual 
institutions at each step of Basel II implementation and 
graduated capital floors for several years prior to full 
implementation in 2012.
    Throughout implementation, institutions will be subject to 
close supervisory scrutiny and a strict leverage ratio 
requirement. Basel II does not include explicit capital 
requirements for interest rate risk, an important issue for all 
institutions but particularly for OTS-supervised institutions.
    The banking industry currently has almost 40 percent of its 
assets in residential mortgages and mortgage-related assets, 
and this number is significantly higher for most OTS-regulated 
institutions. Interest rate risk is especially important for 
mortgage products, and one of the most important risks 
confronting mortgage lenders must be addressed uniformly with 
guidance from our Federal banking agencies on how to measure 
and manage this risk.
    Any discussion of Basel is incomplete without a discussion 
of the interrelationship between leverage and risk-based 
requirements. This issue has spawned a substantial amount of 
dialogue about whether there should be a leverage requirement 
at all which has, unfortunately, created more heat than light.
    OTS supports a leverage ratio, which we view as a mainstay 
of our regulatory system. As a final note, I would urge a point 
previously made by my predecessors at the Office of Thrift 
Supervision; that is, Mr. Chairman, to consider legislation 
supporting OTS' representation on the Basel committee. I think 
it is important that OTS' international role be formalized for 
a number of reasons, not the least of which is the potential 
impact of Basel II on the institutions and the holding 
companies that we regulate.
    Thank you.
    Chairman Shelby. I thank all of you.
    I touched on this in my opening remarks. One of the key 
concerns about Basel II is its impact on the competitiveness of 
small and medium-sized banks and how that could relate to our 
economy, because as we all know, 75 to 80 percent of our job 
creation in this country comes from small businesses, medium-
sized businesses, which deal with small banks in communities 
from coast to coast, and I think it would be an unfortunate 
result if instead of improving the capitalization of the U.S. 
banking industry, Basel II instead created a regulatory 
framework biased toward large financial institutions.
    Basically, we have the most dynamic and healthy banking 
systems here in the world, because we have a competitive 
banking system, all the banks in this country. Since I believe 
it is critical that Basel II does not dampen the 
competitiveness in any way of the U.S. banking industry, 
Governor Bies, I pose this to you: What type of analysis have 
you conducted, and when I say you, the Fed, or do you plan to 
conduct on the likely competitive effects of Basel II? In 
particular, has any of your research indicated that Basel II 
may hasten the trend of consolidation in the banking industry? 
Is that one of the goals here?
    Ms. Bies. Mr. Chairman, it is not one of our goals to 
foster consolidation of the banking industry. We have completed 
several studies of particular loan portfolios and mergers and 
acquisitions, and let me talk about the loan portfolio piece 
first.
    Chairman Shelby. Okay.
    Ms. Bies. When we looked at mortgages and small business 
loans, we found there might be a small impact, and we propose, 
in the Basel I amendments, to address these potential impacts. 
We will get those comments to the advanced proposed rulemaking 
that we just put out, and try to make sure that we follow 
through with that in the final NPR in Basel I.
    We have already had quite a bit of dialogue with the 
community and regional banks, all of the agencies, in order to 
come up with the ANPR, and we will address it. We have just 
completed a study that was led by the Federal Reserve Bank in 
Philadelphia around the credit card competitiveness, that is 
being vetted by all the agencies now, and we hope to make that 
public within the next few weeks.
    In terms of mergers and acquisitions, one of the challenges 
that I think of when in terms of capital and something that 
people need to realize is that we have had a dramatic change in 
the accounting for mergers in the past couple of years.
    In the days of pooling, when you just added two banks 
together, if the bigger bank had a higher amount of leverage, 
you could carry it through. Now, we are in a world where every 
acquisition is a purchase accounting transaction. What that 
means is that when a large bank buys a small bank, on day two, 
the large bank has no new capital, has all of the assets and in 
our methodology risk exposures of the smaller bank and a 
probably added good will, which reduces its regulatory capital.
    Chairman Shelby. It is what you bought.
    Ms. Bies. It is what you bought, and the purchase 
accounting reflects that.
    The only way the bank can even get to even or ahead is the 
old fashioned way: Issue stock. And if they issue stock to the 
selling shareholders, there will be an impact on capital. Or 
they may go to the market, or they may use retained earnings. 
But the only way any merger creates capital above what is used 
in the merger is by issuing equity, and we think anytime you 
issue equity, whether there is a merger or not, that is 
capital.
    Chairman Shelby. The Basel I-A release indicated that there 
were competitiveness concerns that prompted the proposal to 
revise existing capital requirements. Governor Bies, is there a 
plan to conduct any analysis on how Basel I-A is likely to 
impact the competitiveness of small and medium-sized banks 
against large banks operating under Basel II?
    Ms. Bies. Once we get closer to formal proposals in the 
NPR, we will try to look at that more intensely. Now, one of 
the challenges we are going to have is to differentiate between 
minimum regulatory capital, which is at the heart of both of 
these proposals, Basel I and II, versus what is held by the 
banks for business purposes.
    And we know for the vast majority of banks of all sizes 
that they hold real capital way above what they need for 
minimum regulatory purposes to demonstrate that they are a 
highly rated institution by the financial markets. And so, we 
will have to differentiate between those in our analysis, but 
as we get closer to the proposal, we will be looking at that.
    Chairman Shelby. By charging banks with the responsibility 
for calculating their capital requirements, that is a little 
different from what we do today, is it not, Mr. Reich?
    Basel II effectively delegates regulatory authority in some 
areas from bank regulators like yourselves to the banks 
themselves. While bank regulators must approve a bank's method 
for calculating its capital requirements, Basel II, as I 
understand it, nevertheless transfers a lot of responsibility 
for the safety and soundness of the banking system to the banks 
themselves.
    Chairman Powell, you are the Chairman of the FDIC. I want 
to pose this question to you. Does Basel II rely too much on 
the judgment of banks rather than regulators? Do banks have the 
proper incentives to accurately calculate their own risks? And 
was Basel II premised on the belief that there were competitive 
pressures to lower capital requirements below what was required 
for safety and soundness? In other words, how do we expect 
banks to be able to ignore those pressures? Is Basel II founded 
on a realistic incentive structure?
    That is a lot of stuff, but you have spent a lot of time on 
this, and you have a big portfolio on safety and soundness, you 
all do.
    Chairman Powell. I think, Mr. Chairman, that clearly, as we 
have all said, because the nature of the balance sheets of 
these large institutions has changed the risk profile has 
changed. So, the way that we measure capital against those 
risks needs to be modified. I support a more rigid risk-based 
capital regime.
    Having said that, you are correct, judgements will be based 
upon the formulas and the input that institution management 
will give to the regulators. But, remember that the regulators 
have oversight and will test those formulas and will look at 
not only the formulas themselves but will also look at the 
overall capacity of management to manage their risk. But, that 
will depend upon the will, very frankly, of the regulators to 
enforce capital standards they believe properly reflect risk.
    Going forward, I think clearly, there will be times that 
the regulators will have to step in and say the formulas are 
flawed. If the formulas do not produce the necessary capital 
that we as regulators believe institutions should maintain, we 
need the will and the courage of the regulators to step in.
    Comptroller Dugan. Mr. Chairman.
    Chairman Shelby. Yes, go ahead, Mr. Dugan.
    Comptroller Dugan. I just wanted to add one point to that. 
It is not the individual bank's model. It is our model. It is a 
model that we have designed. The differences come in the inputs 
to the model and what the institutions do with them. And, we do 
have a responsibility to supervise that process, as we do now 
with other types of inputs.
    Chairman Shelby. And to supervise that process, you are 
going to have very sophisticated personnel, are you not? 
Because they are going to have them.
    Comptroller Dugan. With regard to, the models themselves, 
you do have to have very sophisticated quantitative experts, 
which we do, and which we will expand over time. The 
supervisory process to make sure that the inputs into that are 
based on sound judgments that are valid does not take the same 
kind of quantitative skills and plays more to the basic 
fundamental, practical judgment of, in our case, national bank 
examiners. We think we do have the skills to do that and 
supervise that process.
    Chairman Shelby. As the Comptroller of the Currency, you 
will have the primary responsibility to supervise them.
    Comptroller Dugan. That is right. Most of the Basel II 
banks are national banks, and we will be on the front lines of 
that supervisory process.
    Chairman Shelby. Senator Sarbanes, I think he has an 
opening statement.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Have you finished your--
    Chairman Shelby. Yes, I will come back. We will go another 
round.
    Senator Sarbanes. Mr. Chairman, first of all, I apologize 
to the panel and to my colleagues for not being able to be here 
at the outset. I will defer my questioning to Senator Hagel, 
but I would like to briefly make an opening statement.
    Chairman Shelby. Go ahead. You are recognized.
    Senator Sarbanes. First of all, Mr. Chairman, I want to 
commend you for calling this timely and important hearing on 
the development of the new Basel Capital Accords. In fact, you 
have had a continued commitment to the Committee's oversight 
function with a focus, of course, on preserving the safety and 
soundness of our banking system. There is a distinguished group 
of witnesses, the regulators, who are here now and in the 
second panel that is going to follow, and we are looking 
forward to hearing from them. We have some very able people on 
that panel as well.
    Let me say right at the outset, I want to congratulate FDIC 
Chairman Powell for undertaking the responsibility of serving 
as coordinator of Federal support for the recovery and the 
rebuilding of the Gulf Coast region. First of all, Chairman 
Powell, we thank you for your tenure as the Chairman of the 
FDIC. I think you have rendered fine service to the banking 
system and to the country in that capacity.
    There is even a deposit insurance bill moving its way 
through the Congress. It went through this Committee quite 
easily in the end after a lot of back toing and froing over the 
years. But you are taking on a very critical and challenging 
responsibility now in dealing with the aftermaths of Hurricanes 
Katrina and Wilma, and I know that you have the best wishes of 
all of us here on this panel, and if there is any way that we 
can be helpful to you in that effort, we certainly want to do 
it.
    Chairman Powell. Thank you.
    Senator Sarbanes. But thank you very much for your service.
    With respect to the subject at hand, I must say, Mr. 
Chairman, this is an important and timely hearing. The last 
quantitative impact study, QIS-4, indicated the possibility 
that Basel II will result in a large scale reduction in bank 
capital. Now, Basel I resulted in an increase in bank capital.
    Half the institutions which participated in the study had a 
reduction of 25 percent or more. One institution had a 50 
percent capital reduction. I do not see how one can avoid the 
conclusion that a reduction of capital on this scale would 
represent a major change in the safety and soundness status of 
our Nation's banking system.
    Second, the Basel II framework is extremely complex. It 
will require banks and regulators to create and operate many 
highly technical financial models. The sheer complexity of 
these models raises concerns of how many people will be able to 
operate, understand, and critique the models and their results.
    Furthermore, if the largest banks, which are to be eligible 
for the Basel II framework, receive large capital reductions, 
it will create enormous pressure to reduce capital for all of 
the other banks for reasons of competitive equity. In addition, 
if risk-based capital is reduced significantly below the 
leverage ratio for the largest banks as a result of Basel II, 
it could create great pressure to weaken or eliminate the 
leverage ratio.
    We must recall that our banks are currently very well-
capitalized. They are very well-capitalized; they are very 
profitable. It has really been a good performance for banks, in 
the general. As a result, it has been a long time since we have 
faced any significant financial crisis. So you base these 
models on recent experience. They may not be sufficient for a 
period of stress in the banking system.
    Moreover, Basel II is premised on allowing the banks 
themselves to determine their own capital requirements. I mean, 
this premise raises a host of regulatory concerns. I mean, it 
is like someone said; I was a teacher; if the students could 
set the exam, they all would have gotten A's.
    So, this is an important hearing. I have a very real 
concern that this thing is just moving down the path, that 
there is a lot of pressure from the other countries that are a 
part of Basel II to get this thing into place and so forth and 
so on. But generally speaking, the pressure for strong safety 
and soundness standards and everything has come from the United 
States, I think it is fair to say.
    And I just think--I know now you had an October 3 meeting, 
I think, of the Basel II, and before the October 3 meeting, you 
put out--did you go for--I will ask it in the question period, 
but my sense of it is this thing is just moving along. I know 
the Fed has had a long, vested interest in this Basel II, and 
presumably, they go to meetings, and all their fellow central 
bankers say, when are you going to do this thing and so forth 
and so on?
    But we cannot let that type of dynamic determine what the 
result is going to be, and if we just keep moving along without 
solving some of these problems that I raised, someday, 
everything may well come to a stop. And then, your problem of 
your relationships will be much more severe than I think they 
are right now. So, I just put that as a--and I will come back 
to some of these in the question period, and I thank the 
indulgence of my colleague.
    Chairman Shelby. Thank you, Senator Sarbanes. I think your 
observations are well taken right here.
    Senator Hagel, thank you for your indulgence.

                STATEMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, thank you.
    Welcome. If I could, I would like to pick up where Senator 
Sarbanes ended and without trespassing on his set of concerns 
and questions, but this will warm the panel up when you get to 
Senator Sarbanes.
    [Laughter.]
    And by the way, Chairman Powell, congratulations on your 
new gainful employment.
    Safety and soundness, what are your concerns about what 
Senator Sarbanes talked about? Do you have any? This is 
somewhat of a departure, and I would like to hear from each of 
you about the issue.
    Mr. Dugan.
    Comptroller Dugan. Senator, as I mentioned in my opening 
statement, I think safety and soundness is why we should go 
forward. I recognize very much the concerns that Senator 
Sarbanes raised about the results of QIS-4. Frankly, if those 
were the results that popped out at the end of the process, 
they would be unacceptable. They are unacceptable. The drop in 
capital is too great. The dispersion in results among similarly 
situated institutions is too wide.
    It was staring at those results that forced the regulators 
to get together and say, what does this mean? Should we go 
forward, or should we readjust? Should we stop now? What we 
came up with is a system that (A) recognized that those results 
were based on a very preliminary read of QIS-4, which, by 
definition, could not be accurate because the system had not 
been built and (B) that we needed to put the system in place 
and supervise the system and see it in operation. Only then 
would we know exactly what the outputs would be from the 
capital process.
    It is our belief that that process, where we have a better 
specified system reflecting the final rule that banks have to 
comply with and banks are subject to rigorous supervision, will 
address some of those issues. But it probably won't address all 
of those issues, and we are going to need to adjust the rules 
once we see the process in operation.
    And so, what we agreed on was the need for a longer and 
controlled transition period where banks cannot drop their 
capital to impermissibly low levels. During that period, we 
need to rigorously supervise the system and see what it does, 
and only when we are comfortable during that carefully 
controlled environment, and after we make changes to address 
problems that we see, do we allow the system to go forward. It 
is our belief that that will address the problems raised by 
QIS-4.
    But to come back to your fundamental point, we believe that 
we need to go in a direction to get our arms around the risks 
that our largest, most complex banks are likely to take in the 
coming years. We at the OCC have three institutions with assets 
that exceed $1 trillion each. They take risks that are 
different and more complicated than the risks taken by smaller 
institutions. They have very complex risk management systems 
already in place to address those risks, which we believe is 
appropriate. And we believe that we will gain a great deal by 
having a common framework across these banks to encourage them 
to develop state-of-the-art risk management systems that we can 
supervise, and it will increase the safety and soundness of the 
system.
    As Albert Einstein said, everything should be made as 
simple as possible--but not simpler. We believe that you have 
to address the complexity of the risk with a system that is 
adequate to do the task. We do not have that now. We need to 
make changes to move institutions in that direction, and we 
think this is the right way forward.
    Senator Hagel. That is the Shelby formula of success, the 
Einstein.
    [Laughter.]
    Chairman Shelby. Absolutely. We try to follow it, but we 
get off track, do we not?
    Senator Hagel. Occasionally. That is why we get up in the 
morning.
    Chairman Shelby. But these people here probably understand 
the Einstein method.
    Senator Hagel. They do.
    Chairman Shelby. We hope they do.
    Senator Hagel. Governor Bies.
    Ms. Bies. Thank you, Senator Hagel. Let me just add a 
couple more thoughts to what the Comptroller just said, and I 
agree with his comments.
    One of the things I think really came out in QIS-4 to 
support why we need to move ahead for safety and soundness 
reasons on the new framework of Basel II are the issues we 
raised; for example, similar credits being graded differently 
as input into the models by different banks have been there for 
ages.
    What happened is that the transparency of having the banks 
look at their models and risks in a similar way, having us look 
at them in a horizontal way comparing them brought more 
transparency to light about the differences in the ways the 
banks actually manage credits and grade individual facilities. 
So that additional transparency is also going to be an 
important new tool to help us do our job better, to be able to 
identify the outliers or the banks that are not following sound 
practice.
    The other thing the effort has done and one aspect that 
came out in July on an international basis and that will be in 
our NPR is that as we have said, there are a lot more 
sophisticated financial instruments out there that the banks 
have exposure to. In July, we adopted a new framework 
internationally, and we will tailor it in the United States 
that really recognizes that the nature of risk in the trading 
book of banks as opposed to the book of loans, has changed 
significantly from what is in the Basel I market risk 
framework.
    And it is grossly inadequate for measuring the risk of the 
kinds of positions that are sitting in trading accounts today. 
If we look at what is sitting in the trading accounts, we are 
seeing not the traditional trading activity where bankers buy 
and sell securities and derivatives all during the day. Instead 
of that, we are seeing about 15 percent on average of the 
assets being comprised of illiquid, high risk positions in 
sophisticated financial instruments.
    Many of these are engineered financial instruments, where 
they take something that starts out as a mortgage loan, goes 
into a mortgage-backed security, gets tranched into CDO's, and 
they are holding equity type risk positions sitting in a 
trading account and not getting the capital treatment for that 
high risk.
    That kind of sophisticated approach, we cannot put within a 
Basel I framework, because the normal small community bank or 
regional bank just does not engage in those types of 
activities. But as we know from derivatives and complex 
transactions, they can blow up very quickly. We need more 
capital. We need a better measure to look at that.
    And then, the other thing that Basel II does, which is 
increasingly important for these banks, and if you look at the 
banks' earnings and shocks to their earnings in the last few 
years, bankers in these large organizations earn more and more 
of the revenue through activities that are related to doing a 
transaction, processing various forms of payments and 
transactions for customers, and none of that is reflected on 
the balance sheet.
    The balance sheet has a very small asset for fixed assets 
or what happens to be there at the end of the day, but there 
are millions of transactions running through there. And when 
there is an operational glitch, all of a sudden there is a big 
earnings hit potential, either through the form of a model 
failure or compliance risk that entails large penalties.
    Operational risk in QIS-4, and this is still being 
developed in the databases, added 10 percent to capital, above 
what the banks would have if they stayed under Basel I. So 
those kinds of changes in these big institutions are why we 
need more effective tools to make sure we have capital to 
address these changing risks.
    Senator Hagel. Thank you.
    Chairman Powell.
    Chairman Powell. Senator, Basel II is a good thing if we 
keep the leverage ratio. I believe it will bring better risk 
management processes and better data for supervisors to 
identify emerging risks as you just identified. But without the 
leverage ratio, Basel II would not be a good thing.
    Senator Hagel. Thank you.
    Mr. Reich.
    Director Reich. Senator, I think safety and soundness is at 
the top of each of our lists of priorities. It certainly is at 
the top of my list, and I believe it is for each of the four 
people at this table.
    Our first guiding principle should be to do no harm to the 
industry today. And I think that the process which currently 
exists, calling for a parallel run in 2008, with capital floors 
graduated in 2009, 2010, 2011, full implementation delayed 
until 2012, and then, only then, with the approval of the 
primary supervisor of each of the Basel II banks, plus the 
continuation of the leverage ratio should provide us with 
essentially a 6-year period of time to get it right and to make 
any changes that are needed to be made during that period of 
time.
    We expect to come out with an NPR early next year. That 
will not be the final word, in my opinion, on Basel II. As we 
go through a 6-year period of testing and observation, I think 
we are committed to make whatever changes are necessary to make 
sure we get it right.
    Senator Hagel. Thank you.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you, Mr. Chairman. I have a very 
deep concern that we are just marching along even though, you 
know, the QIS had terrible results.
    Everyone says, well, we are going to fix it. Just leave it 
to us; we are going to fix it. And you keep moving down the 
path. Then, we are going to have a transition period. But of 
course, at the end of that transition period, you are going 
down what? Ninety-five, 90 and 85 percent, I think, so, we are 
still moving along the same path.
    I think you need to tell your international partners there 
are serious problems here. You probably should say to them 
look: The Congress may nix this thing altogether. We have to go 
back and do some careful rethinking. These consequences that 
were shown in the QIS are unacceptable. Let me ask you: Does 
anyone at the table today think the U.S. banking system is 
overcapitalized? I see everyone shaking their head no. Ms. 
Bies, you did not shake your head one way or the other, so I am 
kind of interested.
    Ms. Bies. I am trying to decide if you are focusing on 
minimum regulatory capital or the real capital that banks hold, 
which is determined by the marketplace, and I think that is 
appropriate. The total capital that the banks hold in the 
system is appropriate for the risks they hold today, yes.
    Senator Sarbanes. During this process of negotiating and 
implementing the Basel Capital Accords, one of the concerns 
regularly raised in the Congress is that the minimum capital 
requirements on federally insured banks should be preserved. 
The regulators, including the Fed, which I understand is the 
lead agency in this negotiation; is that correct?
    Ms. Bies. We have tried to work all of this through in a 
joint way for the United States, and we are working jointly 
toward an NPR.
    Senator Sarbanes. What do the regulators in the Fed think 
about all of this, not the economists but the regulators within 
the Fed system? What do they think about all of this? Are they 
concerned by this lowering of capital?
    Ms. Bies. I think all of us were concerned about the 
results of the QIS-4, and that is why we all, field examiners, 
economists, as well as the regulatory staff all felt we needed 
to do a time out and find out why we got the results that we 
did.
    We have engaged in the whole process through the Fed, both 
the participation of people through the various Reserve Banks 
who are the examiners on these complex institutions and have 
had very good participation and really look through and analyze 
the data, and we have done this with the other agencies. So we 
are concerned about it, and some of the things that show up in 
the NPR based on today's information we hope will address some 
of those areas.
    But as has been said by some of my colleagues, one of the 
challenges here is we have to give the banks enough definition 
of where they need to enhance their models so they can get on 
with it and deliver the information so that we can recalibrate. 
We will revise this. Basel I has been amended 25 times already 
before this proposal. We are not going to go 6 years on Basel 
II without an amendment to whatever we put out in this NPR 
coming out early next year.
    Senator Sarbanes. Yes, but once you move to a NPR, then, 
you have crossed an important threshold. Let me ask you this 
question: We have been assured by the regulators that minimum 
capital requirements would not be affected by Basel at various 
hearings 
before this Committee, correct? Then, Ms. Bies, I read in the 
American Banker, which, of course, we follow closely, Ms. Bies 
said the leverage ratio down the road has to disappear.
    I would say to the industry if you work with us and be 
patient, we understand the concerns about leverage ratios, and 
as we get more confidence in the new risk-based approach, it 
will be easier for us to move away from the leverage ratios. Is 
it your view that leverage ratios have to disappear?
    Ms. Bies. Senator, I did not choose my words well in that 
meeting. I have tried to make amends to that Q and A that I 
handled. In my written testimony here, my oral testimony, my 
testimony in the House in May and every speech I have given on 
capital since then, I have clearly stated that the leverage 
ratio needs to stay in place. And in the context in which that 
was answered, I wish I had answered it in a much more effective 
manner. We are committed to keeping the leverage ratio in 
place.
    Senator Sarbanes. Was there a suggestion in that exchange 
that the cost of implementing--in exchange for the costs of 
implementing Basel II, the Fed would work to eliminate the 
leverage ratios?
    Ms. Bies. No, we are not working on eliminating the 
leverage ratio. We have no staff working on that at all.
    Senator Sarbanes. Where are the banks looking to get the 
recompense for the costs involved in instituting these complex 
models to do the risk-based capital calculations?
    Ms. Bies. Senator, I think as prudential supervisors, what 
Basel II effectively does is sends a message to the industry 
that if they are going to be operating large organizations that 
are difficult to manage in an enterprise-wide basis and deal 
with sophisticated transactions, we expect a quantum leap in 
the quality of their risk management, and this is part of it. 
We want models that are used by the bankers as well as by the 
regulators.
    And so, this is part of the cost of doing business as part 
of a large, complex organization. We feel it is necessary for 
safety and soundness supervision purposes.
    Senator Sarbanes. Would you say that the large financial 
institutions are operating on the premise that there will be a 
significant reduction in the amount of capital they have to 
carry as a consequence of Basel II?
    Ms. Bies. I think there may be a few, because they are 
saying that today's capital framework, given their mix of 
business that they choose to be in in the aggregate requires 
more capital than they feel is appropriate. What we are trying 
to do in this Basel II framework is make it sensitive to the 
business mix of each of the firms, and the proof will be in the 
results of these models.
    Whether their expectations are met or not, we want to make 
sure there is enough capital for their particular 
organization's risk that is inherent in that bank. If we do not 
feel that their risks are really low, their capital is not 
going to drop at all. And so, what we have here is trying to 
get better sensitivity, because the mix of the businesses are 
very, very different across these large organizations.
    So we are going to likely have more variability in minimum 
regulatory capital than we have today, but for each 
institution, it should be appropriate for the risks, and that 
is why we are making them invest in these models, to 
demonstrate how well they manage these risks.
    Senator Sarbanes. I understand that under the QIS-4, a 
significant number of the institutions that are currently 
adequately or well-capitalized would have their status changed. 
Their safety and soundness would lessen; that none of those 
institutions are critically undercapitalized today, but some of 
them would be under the application of the Basel II; is that 
correct?
    Ms. Bies. That is incorrect, Senator. QIS-4IV was a test 
along the way of a process that is going to stretch forward for 
6 more years. None of us, and we are unanimous, would have 
qualified any one of the 26 banks who participated in QIS-4 to 
move forward with Basel II. Their models, their data, are not 
ready for it.
    And so, right now, it is a work in progress. We are meeting 
with each of the bankers this month so that we can talk to them 
about what we observed in their submission in the exercise both 
quantitatively as well as process-wise and emphasizing what 
they need to do to try to qualify. None of them would have, and 
that is why the results in and of themselves are really not 
indicative of what will happen once the models and databases 
are complete.
    Senator Sarbanes. Well, you are talking about a changed 
analysis. But on the existing analysis, what I stated is 
correct, is it not? I mean, the answer you are giving me is not 
that what I stated is incorrect but that, well, we are going to 
change the criteria or the standards, and we are going to get a 
different result. But I am looking at Chairman Powell's table 
here. Have you seen this table?
    Ms. Bies. Yes, sir.
    Senator Sarbanes. What do you think about that?
    Ms. Bies. What I am telling you is that I interpret the 
information very differently. We had some banks who basically, 
for some of the elements, did not have an estimate for an 
extreme loss and plugged a zero because they did not have a 
number.
    Well, to put in a zero for the extreme losses, which is 
where you need capital, we would not allow that to be used. But 
in the model that they submitted, it is there as a zero, and 
that is part of the reason these numbers went down. We would 
not accept that. So to hypothetically say this is what the 
results show, surely, I mean, mathematically, they may. But 
what I am saying is we would never accept it. These banks would 
never move to Basel II, any of them, based on the quality of 
the information they gave us. We would not let anybody start 
the transition based on what they gave us.
    Senator Sarbanes. Well, my time is up. That answer seems to 
me is like a ship passing in the night. It does not really come 
head to head with what this problem is. It seems to me if you 
are going to put out this thing, it then has to show a result 
that is acceptable, and obviously, this does not come anywhere 
close to doing it. But nevertheless, you are going ahead.
    Ms. Bies. But the banks need more specific guidance from us 
on what these expectations are so that they can move ahead to 
complete their work. They all are still working very hard to 
complete their models, and they need it so we can do a more 
rigorous test.
    Senator Sarbanes. My time has expired. I guess in the end 
the question that should be put is, suppose you did not do 
Basel II? What would be the bad result of that if you did not 
do Basel II? We have good capital standards right now. The 
banks are extremely profitable. We do not have this problem 
with a competitive disadvantage. Anyhow, my time is up and----
    Comptroller Dugan. Could I respond to that?
    Chairman Shelby. Mr. Dugan wants to answer that.
    Comptroller Dugan. That last question, Senator.
    I will tell you I sat in this hearing room behind you 
during the period in the late 1980's and through the changes 
that caused banks to have incentives to raise their capital.
    Chairman Shelby. The crisis.
    Comptroller Dugan. That is right.
    Senator Sarbanes. Scars you for life.
    Comptroller Dugan. Yes, and we believe that banks have 
raised capital appropriately, and it is a fundamental part of 
our system. The results from QIS-4 were frankly totally 
unacceptable. We cannot have a system that produces such 
results.
    If you ask, on the other hand, what would happen if we do 
nothing, we think, our supervisors think, not just me, and we 
supervise the largest of these institutions, that it is 
absolutely critical that we have a sophisticated risk 
management system and model conceptually like Basel II, a model 
that we build, not the banks, to get our arms around the most 
complex risks of these institutions, and that we have a process 
that will allow us to address what came out of QIS-4 so that we 
can fix it before these institutions can go live.
    That is why we stretched out the transition. That is why we 
required a much more carefully controlled environment where 
cannot drop their capital, no matter what Basel II says, during 
that period, and why we have anticipated we are going to have 
to change this rule at some point in the future when we see 
what it looks like, when we have built it to specifications, 
when we have supervised it, and when we see what the results 
are at that time.
    We think that approach will address part of the problem, 
but in the end, we are going to have to make some changes. But 
for safety and soundness reasons, we think it is a 
fundamentally good idea to go forward.
    Senator Sarbanes. My time has expired, and I know the 
Chairman has other questions. We have a very good panel coming. 
I have looked at some of their statements. I suggest to this 
panel that you give careful study to the submissions that are 
coming to the Committee from the next panel we are going to 
hear from, because they have raised some pointed questions 
about the situation.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank you, Senator Sarbanes, for your 
experience and your service here and your long-term memory from 
many, many crises; we were both here together, probably the 
only two left, maybe; Senator Dodd, from the crises. Mr. Dugan 
was here and so forth. But I do not believe there is any 
substitute for capital. I mean, you have to do it, and as 
Senator Sarbanes said, our banks are doing very well. Our 
economy is good.
    But things will happen, and they will be challenged. They 
always are. And I hope, as regulators, that when the system is 
challenged that these models, whatever they are, will withstand 
the challenge they sometimes will be in and sometimes they will 
break. I hope whatever you do, you do it the right way. And we 
have this responsibility to question this, as you well know.
    We thank all of you for your service, and we thank you for 
your participation here today.
    Chairman Shelby. We will go to our second panel: Mr. 
William Seidman, no stranger to the Banking Committee, who has 
served this country very well; Mr. William Isaac, I would say 
the same thing, former Chairman, now Chairman of Secura Group, 
LLC; George Kaufman, Professor of Finance and Economics, Loyola 
University, Chicago; Mr. Daniel Tarullo, Professor of Law, 
Georgetown University Law Center; Ms. Katherine Wyatt, head of 
Financial Service Research Unit, New York State Banking 
Department.
    As I said earlier, your written testimony of this panel 
will be made part of the hearing record, and Mr. Seidman, we 
will start with you, if you are ready to sum up any points that 
you want to make. Your written testimony, all of you, it will 
be made a part of the record. I know you have a tight schedule, 
but we have stacked votes, too, later on. We are not going to 
push you too hard, but we think this is a very important 
follow-up panel from the first.
    Proceed, and welcome again to the Committee, sir.

       STATEMENT OF L. WILLIAM SEIDMAN, FORMER CHAIRMAN,

             FEDERAL DEPOSIT INSURANCE CORPORATION;

         FORMER CHAIRMAN, RESOLUTION TRUST CORPORATION

    Mr. Seidman. Thank you very much, Chairman Shelby and 
Senator Sarbanes. It is a great pleasure to be back here. I 
hope you will realize it has been a long time, so I am probably 
a little rusty and, you know, not quite as well-informed as I 
used to be. So, I will just try to hit some high points based 
primarily on my experience. I mean, you have heard some people 
who are all up-to-date.
    Senator Sarbanes. Seidman rusty is better than most people 
well-oiled.
    [Laughter.]
    Mr. Seidman. Thank you, Senator. That is very kind of you.
    First, I was there when the Basel I standards were created, 
I was part of putting that together. And the idea was that 
there were certain banks around the world that were 
undercapitalized that were part of a global system, and the 
whole effort was to get a minimum capital in the global system 
so that if something happened, we would not have weak links.
    So the idea was to have a uniform, simple standard which 
could be applied worldwide, and I think essentially that was 
accomplished. And it was a simple standard that people could 
understand.
    Basel II, of course, is not simple. Here are the regs for 
Basel II right here. I can just about lift them up. That is the 
regs for Basel II. They have been working on for 7 years, and 
as you have heard----
    Chairman Shelby. Does anybody understand them?
    Mr. Seidman. Not me, I guarantee you that.
    Chairman Shelby. If you do not understand them, I would be 
nervous----
    Mr. Seidman. I do not think anybody would be willing to 
take a test on that right now.
    Chairman Shelby. Go ahead.
    Mr. Seidman. So our experience with minimum capital 
standards and with capital standards in general was when there 
is stress, they are too low. I can tell you that if capital 
standards had been any lower than they were back in the 1980's, 
our two largest banks would have failed, without question. They 
were right on the edge.
    So the idea that we would like to have less capital, and 
let me just comment that do you remember Walter Wreston's 
famous statement that big banks do not need capital? And that 
is true until there is a crisis, because as long as you are 
making money, they do not need capital. What they need it for 
is the unexpected, and that is what I think we are all trying 
to work on.
    Our experience with actually using these models, the only 
experience I am aware of in the United States is the GSE's, 
where, as you know, it took 4 or 5 years to create a model, and 
it was absolutely useless when it came to the problems they 
had, because how are you going to model the improper 
accounting? So if you had been using their model obviously did 
not provide protection.
    I thought it was interesting: Chairman Greenspan, who, as I 
last remembered, was a part of the Fed. They asked him the last 
thing, the last hearing what do you think about using models 
for setting regulatory standards? And he said, well, I think it 
is a good idea. And then, he said are you ready to do that 
today? And he said no, the models are not ready. And then, they 
said, well, when can we use them? He said it will be a very 
long time before we--so even the Fed Chairman is pretty clearly 
in doubts.
    And of course, you have heard about the differences between 
large banks and small banks, and I will not dwell on that. Let 
me make clear: I think the models that are being made by these 
banks are very useful. They are useful for current operations. 
That is what they are designed to do. They are useful for 
pricing. They are useful for a lot of things. They are a factor 
in setting regulatory standards. But in no way that I can think 
of can you build a model that would be the basis for absolute 
standards of required capital.
    I think there are some adjustments to Basel I necessary, 
and we have I-A, and I think we have people well-evaluated, who 
can evaluate that.
    Finally, I would just like to quote from one of the learned 
professors on the Berkeley faculty, and his basic quote is: 
``Everyone knows when to discard his models. Of course, we 
understand that even in normal times, the best model is just a 
guide. If something extraordinary happens, like Russia's 
problems or the stock market goes down 20 percent, anyone with 
a modicum of common sense knows that models are not going to be 
reliable guides.'' That's when you need the leverage ratios.
    Thank you.
    Chairman Shelby. Thank you, Mr. Seidman.
    Mr. Isaac, welcome again to the Committee.

        STATEMENT OF WILLIAM M. ISAAC, FORMER CHAIRMAN,

             FEDERAL DEPOSIT INSURANCE CORPORATION;

                  CHAIRMAN, SECURA GROUP, LLC

    Mr. Isaac. Mr. Chairman, Mr. Sarbanes, I appreciate the 
opportunity to be here. This is a very important hearing. The 
Basel II debate is probably one of the most profound debates we 
are facing in the banking system right now.
    As I explained in my written statement I have grave 
reservations about Basel II, and I believe it carries the 
potential to do enormous harm to our banking system, which is 
the strongest, the most profitable, and the most innovative in 
the world. No regulator, legislator, or banker who lived 
through the banking crisis of the 1980's, which those of us who 
are in this hearing right now did, can ever forget the lessons 
of that period, and one of the most important is that capital 
matters.
    And I agree with Chairman Seidman, that we would have had a 
lot more banks fail if we had had less capital in the system. I 
do not believe that the U.S. banking system has too much 
capital. You asked that question to the earlier panel. I would 
state that in my opinion, the U.S. banking system does not have 
too much capital. The rest of the world has too little capital, 
and the United States should not go down to world standards. 
That is not the problem. The problem is we need to try to find 
ways to bring the rest of the world up to U.S. standards, and I 
do not think we should play any games with that.
    We have spent 25 years trying to build a great banking 
system and increase the capital levels in this country. We have 
done it, and we have the best system, and it is not time to try 
to fix it. Basel I was developed in the 1980's to bring 
uniformity around the world and also to try to calibrate the 
capital ratios to the risks in the banks.
    Despite its objectives, Basel II has done nothing to bring 
about parity in capital standards around the world. The 20 
largest banks in the world outside the United States at the end 
of 2004 had a median capital to assets ratio of 3 percent. 
That, I might add, is below the minimum standards required for 
U.S. banks. That is the median. The median among the 20 largest 
banks in the United States was 6 percent, so twice as high, and 
yet, the U.S. banks had much higher returns on assets. The 
argument that U.S. banks are disadvantaged in the international 
marketplace is fallacious. We have the best banks. We have the 
strongest banks. Our banks are taking the fewest risks, and 
they are making the most money. And so, I do not see the 
competitive inequity that exists.
    When Basel I came into place, most of the career bank 
regulators were skeptical about it, because when you said we 
are going to give different risk weightings to different asset 
classifications, they did not know what would happen to 
capital. So they quite wisely put in place the leverage ratio 
to make sure that capital standards did not go too low and they 
also gave themselves the ability to override Basel I at any 
point that they felt that they needed to. For example, in 
subprime lending, the regulators are requiring a lot more 
capital, risk weights above 100 percent on high risk lending, 
something that they reserve the power to do despite what Basel 
I may have said.
    But almost since Basel I was adopted, the Committee at 
Basel, at the Bank for International Settlements, started 
agitating for a more sophisticated risk system for the more 
complex banks. My major concerns about Basel II are first of 
all that it will be based on inadequate and unreliable data. No 
bank in this country has detailed data on losses that goes back 
as much as 10 years. How can we build models when we do not 
have data that takes us through various business cycles?
    The past 10 years is the most profitable period in U.S. 
banking history, and we cannot base models on that period. 
Moreover, the banks that we are trying to get to build these 
models did not exist 15 years ago for the most part, at least 
not in close to their current form. Their names may have 
existed, but those banks do not resemble anything like what 
they did 15 years ago. They are amalgamations or mergers of 
very disparate cultures, data systems, and business practices. 
Even if we could go back 15 or 20 years with these banks, it is 
not the same bank it used to be. And so, I am not sure how they 
build models from that.
    Another concern I have with Basel II is trying to get the 
banks to model their operational risks. I only know of two 
kinds of operational risks: Those that you can identify, 
predict, price, and insure against--those have never been a 
problem in our banking system, because you can predict them, 
you can price them, and you can insure against them. Then there 
are operational risks you cannot predict. I do not know how you 
build a model around something you cannot predict. So, I think 
the whole notion of creating a model for operational risks and 
basing capital requirements on the model is flawed.
    I think one of the things we need to be concerned about 
with Basel II if it goes forward in anything approaching its 
current form is that it might well-foster a complacency and a 
false sense of security on the part of bank management, and on 
the part of bank boards of directors, bank regulators, and 
analysts. I am concerned that people get a false sense of 
security from the models. They will have more confidence in 
them than they deserve.
    And you do not have to go back very far in history to find 
out what happens when you do that. Long Term Capital in 1998 
was a company that allowed, by all accounts, brilliant 
mathematicians and Nobel Prize-winning economists to create 
models and build a firm based on those models. They made some 
huge bets, and they lost. It resulted in the Federal Reserve 
forcing the banking system to come in and bail out the company.
    I think that the argument that U.S. banks are at a 
disadvantage vis-a-vis foreign banks is simply wrong. I heard 
this argument in the 1970's and 1980's about the Japanese 
banks--that they were going to rule the world. We hear very 
little about the Japanese banks today except that they are a 
real drag on the Japanese economy. They pursued growth with 
reckless abandon. They did not have capital. They did not have 
earnings. Their business model was not sustainable, and it 
failed.
    I do not know of a single professional bank supervisor, 
someone who does it for a living, not part-time, I do not know 
of a single professional bank supervisor who is enthusiastic 
about Basel II, and I really do not know any bank CEO's who are 
enthusiastic about it. Capital regulation, in my judgment, 
should be simple and easily understood. It is foolhardy to 
accept a capital regime that will be virtually impossible for 
senior management, boards of directors, regulators, and market 
participants to understand.
    There is nothing wrong with the current capital regime in 
this country that some relatively simple fixes to Basel I could 
not cure. I think Basel II is a good exercise. I agree with Mr. 
Dugan, for example, on the previous panel when he said it is 
important for bank regulators and bank managements to get their 
arms around different kinds of sophisticated risks. I agree 100 
percent, but Basel II it should be a management tool and a 
regulatory tool; we should not base our capital standards on 
it.
    The last thing in the world that U.S. regulators should do 
is engage in a competition in laxity with supervisors in other 
countries by lowering U.S. standards to international norms. We 
have the best and strongest system. We should work hard to keep 
it. Thank you.
    Chairman Shelby. Thank you, Mr. Isaac.
    Professor Kaufman.

           STATEMENT OF GEORGE G. KAUFMAN, CO-CHAIR,

          U.S. SHADOW FINANCIAL REGULATORY COMMITTEE;

          AND JOHN F. SMITH, JR., PROFESSOR OF FINANCE

            AND ECONOMICS, LOYOLA UNIVERSITY CHICAGO

    Mr. Kaufman. Thank you, Mr. Chairman, Senator Sarbanes. It 
is a pleasure to testify before this Committee on the public 
policy implications for the health and safety of the banking 
system and the U.S. macroeconomy of the proposed Basel II 
capital standards. I will summarize my longer written 
statement.
    Basel and structured early intervention and prompt 
corrective action in this country have different histories. The 
capital standards constructed in Basel I in 1988 effectively 
resembled guidelines at the time for best practices in bank 
capital management; in particular, with respect to 
incorporating credit risk exposure. In contrast, in the United 
States, emphasis was not on developing best practices schemes 
but on developing public policy measures to prevent a 
reoccurrence of the large scale failures of thrift institutions 
and commercial banks in the 1980's, which imposed high costs on 
the insurance agencies and for thrift institutions also on the 
taxpayers.
    The structure was designed to turn troubled institutions 
around before insolvency, primarily through recapitalization or 
merger with healthier institutions, and failing that, as a last 
resort, to legally close and resolve them at lowest cost to the 
insurance agency and potentially also to taxpayers.
    With its emphasis on risk-based capital, pillar one in 
Basel II basically remains a best practices guide for internal 
bank management and not a public policy instrument. While there 
is substantial empirical evidence of an inverse relationship 
between leverage ratios, which use total assets and not risk-
rated assets, and bank insolvency, there is no such evidence 
between risk-based capital ratios and bank insolvencies.
    In other industries, analysts do not compute risk-weighted 
assets or risk-based capital ratios for individual firms. But 
they do compute, and investors use, leverage ratios. Risk-
weighted assets are an inferior scaler to the total assets to 
gauge how much capital is available to a bank before the value 
of its total assets declines below the value of its liabilities 
and it becomes insolvent.
    Unfortunately, Basel II may be on the verge of causing 
major mischief in the United States that could weaken financial 
stability. It appears that the 4 percent risk-based tier one 
capital requirement ratio can be achieved under Basel II for 
many large banks intending to use the advance internal ratings 
approach with lower capital than is currently required both 
under Basel I and to be classified as an adequately capitalized 
bank according to the 4 percent tier one leverage ratio.
    Consequently, the leverage ratio is likely to become the 
binding constraint for these banks and prevent a reduction in 
required regulatory capital. The FDIC has concluded that, 
``U.S. policymakers will be confronted with a choice between 
ignoring the results of Basel II or substantially weakening the 
PCA requirements.''
    Although almost all U.S. banks currently maintain capital 
ratios at well above the regulatory requirements--indeed, the 
FDIC reported that bank equity capital ratios at mid-year 2005 
climb to the highest levels since 1938, more than twice the 
ratio required to be adequately capitalized--some large banks 
appear to be lobbying U.S. regulators to lower the numerical 
threshold capital leverage ratio to qualify as adequately 
capitalized to below 4 percent, say, to 3.5 percent or lower.
    Congress in FDICIA delegated to the appropriate Federal 
regulators the setting of the numerical thresholds for all 
tranches but the minimum critically undercapitalized closure 
trigger of 2 percent of equity capital. Some large banks are 
also arguing that the current leverage ratio requirements put 
them at a disadvantage with their competitors in the rest of 
the world, who are not subject to these ratios.
    For U.S. regulators to cave in to such pressures would be a 
big and costly mistake. Considerable evidence suggests that 
even a 4 percent equity leverage ratio is lower than that 
maintained by almost all domestic nonbank competitors of banks 
who are not similarly regulated nor covered by a safety net. 
When industry leverage ratios fall below 6 percent capital, 
bank failures increase, particularly in a recession.
    Indeed, on the whole, there is a negative relationship 
between leverage ratio and defaults in all industries. With 
respect to individual large banks, there is no evidence either 
that equity capital increases the bank's overall cost of funds 
or that there is an inverse relationship between bank capital 
ratios and bank returns on either assets or equity.
    A time series analysis for U.S. banks shows a weak positive 
relationship between bank capital and profitability. A cursory 
cross-section analysis of the world's largest banks also shows 
a positive relationship between capital and profitability since 
the 1980's. Recently, United States, United Kingdom, 
Australian, and Spanish banks have both high capital ratios and 
high profitability, while German, Swiss, and Japanese banks 
have both low capital ratios and low profitability, although 
some adjustment need be made for the possibility of 
simultaneity in the direction of causation.
    Nevertheless, this helps to explain why capital ratios 
actually maintained by U.S. banks are considerably higher than 
the regulatory requirements. They are signalling strength to 
their customers. Likewise, among the largest 1,000 banks in the 
world in 2003, U.S. banks accounted for only 15 percent of 
aggregate assets but 22 percent of aggregate tier one capital 
and fully 37 percent of aggregate pretax profits.
    To summarize, adoption of Basel II for large banks in the 
United States is likely to have little effect on the banks and 
the economy if the current numerical threshold values for the 
leverage ratios for adequately and well-capitalized banks are 
not reduced. It would do little damage. If, however, because 
the new Basel II risk-based requirements can be met, on 
average, with lower leverage ratio numbers, the numerical 
definitions for adequately and well-capitalized banks and PCA 
were reduced, there are likely to be longer-term adverse 
consequences. The integrity of prompt corrective action should 
not be compromised for the sake of harmonizing bank capital 
standards across countries.
    But the Basel process has not been totally negative. It has 
greatly improved the measurement and management of risk by both 
bankers and regulators and thus enhanced financial stability 
worldwide. Basel should be maintained as an ongoing process to 
develop ever-better bank best practice schemes for internal 
management purposes. But it should not be halted and put in 
place in the United States. It is the process, not the end 
result, that will provide the major benefits.
    Thank you.
    Chairman Shelby. Thank you, Professor.
    Mr. Seidman. Mr. Chairman, I am sorry; I apologize.
    Chairman Shelby. Mr. Seidman.
    Mr. Seidman. I have to leave. But I agree totally with my 
predecessor, Mr. Isaac, so anything that he says, I subscribe 
to.
    Chairman Shelby. You are going to associate with him. Well, 
we appreciate you. We appreciate your appearance. We know your 
time constraint.
    Mr. Seidman. Sir, thank you very much.
    Senator Sarbanes. Thanks very much for coming. It is nice 
to have you back before the Committee.
    Mr. Seidman. Thank you.
    Chairman Shelby. Mr. Tarullo, am I pronouncing your name, 
right, Tarullo?
    Mr. Tarullo. Tarullo, correct.
    Chairman Shelby. Thank you.

                 STATEMENT OF DANIEL K. TARULLO

          PROFESSOR, GEORGETOWN UNIVERSITY LAW CENTER

    Mr. Tarullo. Thank you, Mr. Chairman, Senator Sarbanes. I 
think you have heard already this morning that there is a lot 
of common ground, the common ground being that there needs to 
be better risk management in banks; there needs to be a better 
capacity in our bank supervisors to understand the risks that 
banks are assuming; and that Basel I is admittedly imperfect 
and becoming increasingly so.
    But those facts do not translate into a policy conclusion 
that we should adopt Basel II. And it seems to me, looking at 
this as a former policymaker, there are two kinds of questions 
that we and you should be asking. First, are we ready to move 
ahead to Basel II, given our current state of knowledge and the 
current conditions in the world? Second, will we ever be in the 
position where Basel II is, on balance, the right approach to 
bank capital regulation?
    I am still somewhat agnostic on the second question, 
although skeptical for a lot of the reasons that you and my 
colleagues on the panel have articulated. I am very clear on 
the first question: We are not ready to move forward; the bank 
supervisory agencies are not ready to move forward; there are 
too many unanswered questions.
    One thing that I think academics and policymakers should 
have in common is an appreciation of the law of unintended 
consequences. When you take a regulatory or other action, some 
things you anticipate, many things you do not. Some of those 
unanticipated things can be very harmful indeed--witness our 
history with the savings and loan crisis and the Latin American 
debt crisis, both of which had some of their roots in prior 
regulatory actions which, in retrospect, were good for the 
economy but where the consequences had not been anticipated and 
guarded against.
    So, again, thinking as a former policymaker, how do I 
understand what the agencies are proposing right now? Well, 
they are saying first, we want to make the biggest change in 
bank regulation in about 15 years. Second, we have tried to 
figure out what the effect will be on bank capital. We are not 
really sure. In fact, every time we do one of these tests, the 
results surprise us. But we have now concluded the only way we 
can really figure it out is to go ahead and implement the new 
process, the new rules, even though we really admit we do not 
understand what will happen.
    Third, to the extent we do understand, there seems to be a 
momentum toward capital reduction. And the agencies have not, 
in my view, and I do not think they did this morning either, 
articulated their theory of where capital needs to be and why.
    This is not a science. There can be and should be 
sophisticated quantitative aids to capital regulation. But 
ultimately, regulatory capital levels are a judgment about the 
amount of safety and soundness, the amount of bank stability 
versus the constraints on banks moving money out the door to 
more productive uses. That is a policy judgment. The market 
needs to make its judgments as to how much risk it wants to 
bear in lending to banks as well. So I think these things ought 
not to be confused.
    Finally, as you look at all this as a policymaker, you have 
to say, okay, what are the costs and benefits we are going to 
get immediately? Why do we have to move so quickly? I think Mr. 
Dugan is absolutely right: Over the medium to long-term, he 
needs to get his arms around what is going on in banks. But if 
nothing happens tomorrow, we are not faced with a crisis. This 
is not a circumstance in which people come to you as 
legislators or to them as regulators and say ``look, we know we 
do not understand everything that is going to happen, but we 
have to move, because the bad things that are happening to us 
are just too great.''
    So, Mr. Chairman, Senator Sarbanes, I appended to my 
testimony a list of just the core questions that I, as a former 
policy coordinator, would have put to agencies proposing to 
move forward and that I urge you as Members of the relevant 
oversight Committee to put to the regulators. They may be able 
to answer them. I genuinely mean that when I say they may be 
able to answer them. But I think what has happened is there has 
been this kind, as Senator Sarbanes was suggesting, a momentum 
to finish. There is a kind of exhaustion. The regulators think 
we have been doing this for 6 years; we are already looking at 
another six. Let us say we are putting it in place right now, 
get it off of the desk, and move on to the next set of 
issues.''
    That is where the role of a policy coordinator or a 
Congress oversight committee comes in--to say we understand you 
are tired of this; we understand it is putting a lot of strain; 
we understand it is very difficult, but we still need to 
understand what the consequences will be before we move 
forward.
    Thank you.
    Chairman Shelby. Thank you. That is very articulate. I 
believe that Senator Sarbanes and I are working together, and 
we will on this issue. We have a lot of questions that we did 
not have time to ask the regulators earlier this morning, and 
some of your suggestions will be very helpful.
    Ms. Wyatt, thank you for appearing here with us.

                STATEMENT OF KATHERINE G. WYATT

               HEAD, FINANCIAL SERVICES RESEARCH,

               NEW YORK STATE BANKING DEPARTMENT

    Ms. Wyatt. Good morning, Chairman Shelby, Senator Sarbanes, 
and Members of the Committee. My name is Katherine Wyatt. I am 
a Ph.D. mathematician and Head of the Financial Services 
Research Unit at the New York State Banking Department. I have 
followed the development of Basel II for the Banking Department 
since 2000. I have studied the possible effects of the simpler 
approaches under Basel II and worked with my Federal 
counterparts in analyzing banks' implementation programs for 
Basel II.
    I appreciate the opportunity to testify today, because I am 
concerned that adhering to the current timetable for 
implementation that the agencies have proposed could lead to 
far-reaching changes in how we measure capital without 
sufficient understanding of the possible consequences.
    The Federal agencies plan to issue the Basel II NPR in 
early 2006, then to finish the rulemaking process for Basel II, 
conduct a year of parallel run of current requirements and 
Basel II, and have Basel II in effect all by January 1, 2009. 
They also aim to have the domestic capital modifications for 
non-Basel II banks or amended Basel I or Basel I-A in effect on 
January 1, 2009, also.
    I am afraid the pushing ahead to complete the rulemaking 
process for two complex proposals in less than 3 years will not 
allow time for essential review of either. Now, there are these 
3 years of floors that they have talked about. However, banks 
that adopt Basel II on January 1, 2009, will have already made 
sizeable investments in systems, in data collection programs, 
and I think it will be very difficult to make material changes 
to the proposal after they become effective, and they are ready 
to start.
    I believe there are two large gaps in our understanding of 
the impact of Basel II that must be addressed before we move to 
a final rule for either Basel II or Basel I-A. First, we do not 
know what the actual level of capital will be under Basel II 
for any given bank. You have heard already this morning about 
the results from QIS-4. They are crude. No one is willing to 
say that this is what the level of capital will be or will not 
be.
    Also, Basel II has changed over time. It was 2\1/2\ years 
ago that the ANPR was released. There has been nothing public 
since then. Now, the timetable seems to involve going ahead 
without another impact study of the fully specified proposal 
after the NPR. Even more importantly, since capital 
requirements under Basel II are based on the outcomes of 
mathematical models, we need time to develop rigorous technical 
guidelines for parameter estimation and tests of data 
sufficiency to ensure that required levels of capital are 
adequate.
    Now, the second large gap in knowledge comes from the fact 
that we have not addressed the changes that may be brought by 
Basel II and Basel I-A across the banking system. Basel II's 
impact has been studied primarily on large, complex banking 
institutions. We have not fully studied the competitive effect 
of Basel II on the close to 9,000 non-Basel II institutions in 
the country.
    It is essential that we study the effects of both Basel II 
and the amended Basel I or Basel I-A that was released just 
last month side-by-side before we go ahead.
    I would like to speak first about banks' Basel II capital 
calculations, if I could. Under Basel II, capital requirements 
for credit exposures are based on the outcomes of a particular 
mathematical model of default specified by supervisors. This 
supervisory model is applied to complicated portfolios with a 
host of adjustments, specifications, exclusions, and exceptions 
that grew out of attempts to reconcile the model results with 
existing international bank regulations. As I said, we will not 
even know what the final U.S. version of these specifications 
will be until early next year.
    Basel II banks provide their own estimates of probability 
of default, loss given default, exposure at default and 
maturity as inputs into the Basel II formulas. These parameter 
estimates depend on the data and other models used by the bank. 
Now, a key premise of Basel II is that banks will have enough 
reliable data to produce rigorous results from the model. I 
think many will agree with me that this is often not the case.
    The schedule for implementation must allow enough time for 
supervisors to work with bank models, to understand different 
parameter estimation techniques, and to gauge the sufficiency 
of bank data. Otherwise, there is a real danger that the 
estimation techniques that most large banks choose will become 
the de facto best practices.
    Unfortunately, Basel II could be gamed by choosing the 
modeling techniques and data sets that will produce the lowest 
capital requirements. We have already seen what the QIS-4 
results showed. The strong possibility exists also that as the 
distance between risk-based capital requirements and current 
leverage under prompt corrective action capital requirements 
grows, there will be increased pressure on bank regulators to 
drop the leverage ratio requirements.
    The bank supervisors I have talked with are very worried at 
the prospect of dropping PCA requirements. They remember other 
times when banks' predictions about the future did not come 
true. They also point to their experience that well-capitalized 
banks are profitable banks, can enjoy lower costs of funding, 
and can more easily weather economic downturns.
    Second, we just do not know enough about the impact of 
Basel II more broadly on the U.S. banking system. The 
Conference of State Banking Supervisors described some widely 
shared concerns about the impact of Basel II in a letter to the 
Federal agencies in September. CSBS wrote: As proposed, Basel 
II creates significant differences between capital requirements 
of banks that adopt Basel II and those that do not. The current 
approach reduces the capital large institutions hold for 
mortgages and small business loans among other assets. In a 
very practical sense, the reduced capital requirements would 
provide a pricing advantage for the larger institutions.
    In a competitive economy, eventually, market forces will 
likely drive these assets from smaller banks toward the Basel 
II adopting banks, requiring nonadopting banks, the vast 
majority of which are small community banks, to move to higher 
risk areas of banking.
    I am afraid that the available analysis does not adequately 
answer these concerns. The Federal Reserve has posted on its 
website several white papers covering some of the competitive 
issues raised by the original bifurcated regime proposed by the 
agencies. However, these papers are based on Basel II circa 
2003, and both the Basel Committee and the Federal agencies 
have made changes since then. The new, amended Basel I 
proposal, of course, is not considered at all in this research. 
The white paper's suggests that the impact on non-Basel II 
banks may be minimal, but these papers are not definitive, and 
other authors have disagreed with their findings.
    We need to have a much better understanding of the 
consequences of Basel II before it is implemented. We should 
take the time now, both Federal and State banking regulators, 
to fully test the impact of Basel II and the amended Basel I 
proposals. In this way, we can work to safeguard the soundness 
and profitability of the banking system, and we can ensure that 
U.S. borrowers will continue to have the access to capital that 
a strong U.S. banking system affords them.
    Thank you very much.
    Chairman Shelby. Thank you, Ms. Wyatt.
    Dr. Kaufman, in your testimony, you indicate, ``there is 
substantial empirical evidence of a negative relationship 
between leverage ratios and bank insolvency but no such 
evidence between risk-based capital ratios and insolvency.'' 
Could you discuss in a little more detail, help us understand 
why is this the case?
    Mr. Kaufman. Because insolvency basically deals with when 
the value of the assets falls below the value of liabilities. 
It has nothing to do with whether the value of risk-based 
assets falls below the value of liabilities. And so, you have a 
factor there that does not seem to fit in logically into the 
framework. Take a bank that holds nothing but very low credit 
risk assets, it would have a very low capital requirement. But 
if anything happens, if the models make a mistake, then, with 
the low capital, you burn right through the capital. Capital is 
a buffer that is to burn through, and the more capital you 
have, the longer it takes to burn through.
    Chairman Shelby. No sponge to absorb it.
    Mr. Kaufman. Right.
    Chairman Shelby. Have you done any work or thinking about 
the likely, if there is going to be macroeconomic impact on the 
U.S. economy of the adoption of Basel I and Basel I-A?
    Mr. Kaufman. I have not focused on Basel I-A. As has been 
said here, the small banks in particular hold so much more 
capital than is required to be held, I do not think it will 
make much of a difference.
    Chairman Shelby. Mr. Tarullo, do you have any thoughts 
there?
    Mr. Tarullo. Senator, there have been quite a few academic 
studies trying to project whether Basel II will exacerbate what 
is called the procylicality of banking regulation, meaning that 
when things are bad, the banks withdraw more money from the 
system, because they have to ramp up their capital 
requirements. And I would just say that at this point, whether 
Basel II will increase procyclicality is another of the 
unanswered questions. The academic studies done to date have 
differed, and some of it differs based on, as Dr. Wyatt was 
suggesting, which assumption you are ultimately going to stick 
into the model.
    Chairman Shelby. Just to the panel, do you believe the 
adoption of Basel II and Basel I-A leave banks with sufficient 
capital or would, Mr. Isaac?
    Mr. Isaac. Well, that depends on what they come out with in 
the end and whether they maintain the leverage ratio. It seems 
to me that the whole exercise they are going through, a lot of 
people expect that capital requirements are going to go down, 
and that was the premise of the----
    Chairman Shelby. Something Senator Sarbanes raised earlier 
and rightly so.
    Mr. Isaac. And I agree. We see people testifying and making 
speeches that we have to do this to keep our banks competitive 
with foreign banks that have much lower capital ratios. So, I 
believe the premise that everybody is operating on is that 
capital ratios are going to go down if Basel II goes forward. 
Small banks say that is not fair to them, so the regulators 
publish Basel I-A, to lower small bank capital ratios as well. 
In other words, we fix the inequity by lowering capital ratios 
across the board.
    Chairman Shelby. Could we be playing with fire, though?
    Mr. Isaac. I think it is a prescription for disaster, and I 
am strongly opposed to lowering capital standards in this 
country.
    Chairman Shelby. Professor Kaufman.
    Mr. Kaufman. I think it all hinges, as has been said a 
number of times, whether you lower the numerical definitions of 
adequately capitalized banks under the leverage ratio. If you 
do not do anything there, then, it really does not matter what 
comes out of the risk-based Basel II analysis.
    The other factor you want to be sure about is that you make 
it quite clear to the banks and to the country as a whole that 
FDICIA makes it very difficult to protect uninsured depositors 
in bank failures--FDICIA coming out of this Committee a number 
of years ago--and, therefore, that the market better hold 
enough capital regardless of what the regulatory requirements 
are.
    Chairman Shelby. Mr. Tarullo.
    Mr. Tarullo. Mr. Chairman, I would echo two things Mr. 
Isaac said: First, we cannot know right now, because these are 
inchoate proposals. Second, there does seem to be a lot of 
momentum toward lower capital, both in the larger banks, in the 
smaller banks that fear the competitive consequences, and I 
noted in Europe, where the adoption of Basel II in the European 
Parliament was touted by European Union officials as lowering 
capital requirements for European banks.
    Chairman Shelby. Ms. Wyatt.
    Ms. Wyatt. Chairman Shelby, first, I would just point out 
that when I have looked at capital ratios, it has struck me 
that already, for many very large institutions, the leverage 
ratio is the constraining ratio. We are already in the 
situation where banks are much closer to the leverage ratio 
than they are to the risk-based capital one.
    I think we just have to know more about the actual 
mechanics of the Basel II programs that banks will have before 
we can say, and until we do have some assurance about what is 
going to come out of these Basel II systems, it would be much 
better to stay with the current capital requirements.
    Chairman Shelby. Competition in the banking community: We 
have large banks, we have a lot of small banks. As I mentioned 
earlier, and you well know, all of you, our economy's job 
creation machine is small and medium-sized business. Mr. Isaac, 
could this have an effect on competition, the banking industry, 
and then get into our economy?
    Mr. Isaac. I think that if the large bank capital standard 
is significantly reduced, and we do not do something about the 
smaller banks, that is going to have a big impact on small 
banks around the country, because they are not going to be able 
to be on the same footing competitively, and it is going to 
hurt them.
    And they tend to reach out and take more risk when they are 
getting hurt competitively, which creates more problems in the 
system. I do not think the answer is to lower the capital for 
the big banks and then respond by lowering the capital for the 
small banks. I think the answer is keep the minimum standards 
where they are and use Basel II as a management tool and as a 
regulatory tool. I actually favor developing these models, 
because I think it will improve supervision and management of 
banks, but I do not see the tie between that----
    Chairman Shelby. Lowering the capital, though, should be 
left out of it.
    Mr. Isaac. Exactly.
    Chairman Shelby. Professor Kaufman.
    Mr. Kaufman. I do not see that as being a very important 
issue. As I pointed out, the small banks in particular hold so 
much more capital than their regulatory requirement now. If you 
go back to the pre-FDIC days and the pre-Fed days, even, when 
we did not have capital regulation, you see exactly the same 
picture as we see now: That the small banks held considerably 
higher capital than the larger banks. They competed with each 
other. They both survived. It is just the nature of the beast 
that when you are smaller, you concentrate your risks more, and 
you are more likely to hold higher capital. So, I do not think 
that the adoption of Basel II will have significant competitive 
implications.
    Chairman Shelby. Mr. Tarullo, do you have any comment?
    Mr. Tarullo. No, I do not.
    Ms. Wyatt. I think we do not know.
    Chairman Shelby. A lot of things we do not know about this.
    Ms. Wyatt. And I am sorry to keep repeating that, but the 
problem is it is not just large banks and small banks. It is 
not just large banks against small community banks. There are a 
whole bunch of banks in between. These large regional banks, 
clearly, it seems to me, are competing with the large banks. 
And their capital ratios seem to be moving closer to the 
capital ratios that the large banks keep.
    Also, I think there are questions about the kinds of 
lending that it will be more profitable for Basel II banks to 
do.
    And if they have already invested in a lot of systems, if 
they have sophisticated data collection programs, it will be 
easier for them, perhaps, to do a certain kind of retail 
lending that can be done where the loans can be pooled or even 
small business loans where you could look at a small business 
loan in a retail sense rather than as a small corporate loan. I 
think there will probably be changes in the ways banks do 
lending because of this, and I think that is one of the things 
we have to look at.
    Mr. Isaac. Mr. Chairman, could I just add one little 
thought to that?
    Chairman Shelby. Yes, sir.
    Mr. Isaac. I think the answer to what is going to happen 
competitively is pretty clear from the fact that something like 
the 10 largest banks are required to implement Basel II if it 
goes forward. A significant number of banks below the top 10 
are moving to implement Basel II at great expense and not 
because they want to opt in to Basel II, but because they fear 
they will not be able to compete against the top 10 banks if 
they do not implement Basel II.
    We do have a system in which everybody is competing against 
everybody right now, unlike the system we had in the 1970's 
where everybody carved up their territories. So, I think we 
have to be very careful about the competitive effects of this. 
We are going to have a bunch of banks opting into Basel II 
because they want to take advantage of lower capital, and I do 
not think they should have lower capital.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thanks very much, Mr. Chairman.
    This has been an extremely helpful panel. We appreciate 
your appearing today, and also, we appreciate the careful 
thought that obviously went into the prepared statements. Mr. 
Chairman, we should send these prepared statements to each of 
the regulators and urge them to review them very carefully. I 
suggested that to them when they were here.
    Chairman Shelby. I think that is a good idea. I think it 
would be probably something that the two of us could work 
together with our staff and propound a number of serious 
questions to all of our regulators that we did not have time to 
do today.
    Senator Sarbanes. Right.
    Chairman Shelby. We could work on that together.
    Senator Sarbanes. Fine.
    I know we are going to have a vote shortly. I want to lay 
the basis for my question, and then, I will put it to you. This 
QIS-4 study which they did, released earlier this year, showed 
that for the 26 participating U.S. banks, the aggregate capital 
level would drop 15.5 percent. The median capital reduction was 
26 percent. In other words, half of the participating banks 
would have capital reductions of 26 percent or more, and one of 
the banks had a capital reduction of 50 percent. But we 
continue to move down this path.
    I mean, you get this kind of study result that just seems 
to me should bring you up short about what is going on, but the 
beat goes on. So now, the banking regulators have put out this 
revised plan for implementation of Basel II framework. By its 
very terms, they are going to put on a minimum 3-year 
transition period, during which the agencies would apply limits 
on the amount by which each institution's risk-based capital 
could decline with the application of Basel II, so it is going 
to go 95 percent, 90 percent, 85 percent over a 3-year 
transition period.
    And then, the institution's primary Federal supervisor 
would assess the institution's readiness to operate under the 
Basel II base capital rules. They would make a decision on the 
termination of the floors, in other words, the 85 percent 
floor, on an institution by institution basis. So what they are 
putting out there envisions going to 85 percent of the current 
risk-based capital levels. I mean, it is built right into the 
proposal.
    Now, I am trying to search for where the motive force or 
the dynamic element is coming from to keep this thing going 
when you get these kinds of results, when we have very able 
testimony here, Mr. Chairman, Mr. Seidman, Mr. Isaac are very 
experienced; Mr. Kaufman, a leading academic; Dan Tarullo, we 
know, and of course, Ms. Wyatt, Diane Taylor is your 
superintendent.
    Ms. Wyatt. Yes, she is.
    Senator Sarbanes. And you all run a good department there 
in New York, the New York State Banking Department, with a lot 
of very able and competent people, and you are one example of 
that.
    And so, why is all of this being ignored? Why do we 
relentlessly keep moving forward down this path when people are 
raising a lot of red flags about what the implications of this 
are? Does anyone on the panel have a theory, a hypothesis, as 
to what is the driving force behind all of this? I see they all 
want to answer. Very good.
    Mr. Isaac. I will just speculate a little bit, because I do 
talk to regulators a lot, and I think I know what is on their 
minds, at least in many cases. I believe this whole effort is 
well-intentioned. We have banks that are huge and increasingly 
complex, and they have all sorts of risks that we are not sure 
that they understand. And so, there is a desire--I think 
Comptroller Dugan expressed it--to get our arms around these 
banks. We need to understand them better, these great big, 
complex institutions.
    So, I think that is the motivation. I think somebody made a 
very strategic mistake 10 years ago or whenever they started 
talking about this in the hallowed halls of Basel, when they 
decided to tie the Basel II effort to capital and to induce the 
big banks to do it by saying, ``You got a shot at lower capital 
if we come up with a system.''
    I think it would have been much better if the regulators 
just simply said, ``We do not know enough about you, you do not 
know enough about you, and we are going to insist that you 
develop these models; no inducements here. Just do these 
models. We know it is going to cost you money, but that is the 
price of being an insured, regulated bank.''
    And then, we can all see what we are dealing with over a 
period of 10 or 15 years; we will perfect these models, and 
maybe then, somehow, that will affect regulation and capital 
requirements and the like. But we should not start there. We 
should keep the system in place that has brought us the best 
and strongest banking system in the world and mandate that 
Basel II be implemented for purposes of management information 
and regulatory information so we can figure these banks out 
better.
    I think they are very well-intentioned. I just think they 
got off on the wrong foot, and it is hard to back off of it.
    Mr. Kaufman. I would agree with what Mr. Isaac just said. 
In my prepared statement, I differentiated between public 
policy tools and best practices, and Basel II basically is a 
best practice as is Basel I. Given that Europe does not have 
the prompt corrective action system that we have in this 
country, they are trying to substitute, without really having 
thought it through, Basel II for prompt corrective action. That 
is not going to work.
    What we also have going is the Europeans pushing the 
Americans at this point. We also have natural bureaucratic 
momentum that is set up. You either stop it, which is difficult 
to do, or you just keep revising it and keep going. I gave a 
talk some time ago in which I suggested if the Basel group 
really wanted to meet in a city named B, maybe they should meet 
in Baghdad or Bogota. That might stop the process.
    [Laughter.]
    Chairman Shelby. That is a good answer.
    Mr. Tarullo. I think there is a lot to what Mr. Isaac said, 
and I would just add the following: I observed frequently when 
again I was in the position of watching agencies come forward 
with proposals that there is an early period where different 
ideas can get some traction. At some point, though, the 
bureaucratics of the agency become set on one idea. And at that 
point, every problem that comes along is a problem to be dealt 
with, to answer it; let us fix this, let us deal with this 
constituency, but we are going down this track, and it becomes 
very difficult for someone to get perspective on it.
    And I think that is exacerbated for bank regulatory 
matters, because as you saw this morning, you have four 
agencies plus the Federal Reserve Bank of New York, which, of 
course, originally was in the lead on this entire issue. All of 
them have to work together. There is not continuity of 
leadership over the course of the exercise. And so, it does 
acquire a momentum of its own. And I think Mr. Isaac has put 
his finger on maybe what gave the push to that momentum in the 
first instance.
    Senator Sarbanes. Is there a view from the State level 
about this?
    Ms. Wyatt. Yes; I have been very fortunate that I have been 
able to be an observer at many meetings, Federal interagency 
meetings on Basel II, and we are very involved in Basel II at 
the State level. We have many banks that are interested in 
Basel II, the larger regional banks. And I think that a lot of 
very useful things have come out of the Basel II process.
    I mean, it has been going on for many years. I think we 
have learned a lot more about banks, and their portfolios have 
started to address some of the complexities that are here. The 
problem just is, though, in my opinion, we are not quite ready 
to go to implementation. I think we need to have a fully 
specified NPR, something with all the details filled in, and 
step back, look at it, look at its effect, look at Basel I-A 
NPR when it is out. Just take a moment to make sure, more than 
a moment, but to be sure before we go to the next stage.
    Senator Sarbanes. Is there not a very important dimension 
that a whole group of banks--it will just work its way right 
down the pyramid--will say to bank regulators, well, you 
allowed this Basel II for these 26 or whatever it is large 
banks. Now, they are holding less capital. But I am still 
having to hold the old levels of capital.
    That is unfair. I am at a competitive disadvantage. You 
have allowed the most complex institutions to drop their 
capital levels. Why should we not be allowed to do the same? If 
you do not allow us to do the same or something comparable, we 
are going to be at a significant competitive disadvantage, and 
will that argument not continue to be asserted right down the 
size chain?
    And that is not really being analyzed here. I mean, this is 
all the focus, what does it do to the 26. But what is the 
spillover or the carryover effect of this on the rest of the 
institutions? Is that a substantial problem?
    Mr. Isaac. I think it is a very clear problem. I agree with 
you completely: It is going to ripple through the system 
because banks below the top 10 are going to opt into Basel II.
    I want to make another point here because I have a special 
concern, having run the FDIC during the banking crisis of the 
1980's and handled the biggest bank failure in our history, 
Continental Illinois. Continental was the eighth-largest bank 
with assets of $40 billion. It stressed the agencies--the Fed 
and the FDIC--and it stressed the banking system.
    I do not know what we will do if one or two of these really 
big ones that we have today gets in trouble, and I think it is 
not a time to be fooling around with lowering capital ratios. 
It just is not. We need to understand a lot more, which is why 
they should keep on moving on Basel II as a management tool and 
as a regulatory tool, but we should not, under any 
circumstances, be lowering capital ratios in these banks in my 
opinion.
    Senator Sarbanes. Well, Gene Ludwig, who had been a former 
Comptroller, made the observation just recently that, we were 
not in a down cycle. He thinks we may have a down cycle in 24 
to 36 months and says, you cannot run these models testing it 
unless somehow you work into the model the down part of the 
cycle. So, I mean, just to underscore the point are making.
    Mr. Isaac. I agree.
    Senator Sarbanes. Mr. Chairman, I see the vote has started. 
This has been a very helpful panel.
    Chairman Shelby. Senator Sarbanes, you have been here a 
long time. You have chaired this Committee, and we both were 
here when Chairman Isaac was going through the crisis. We went 
through the crisis, and we do not want to go through another 
one.
    Mr. Isaac. I do not either.
    Chairman Shelby. We appreciate all of your testimony, your 
input, and we are going to look closely at some of the 
questions Mr. Tarullo and others have suggested, because 
Senator Sarbanes has a lot of questions to be asked.
    Thank you so much. The hearing is adjourned.
    [Whereupon, at 11:41 a.m., the hearing was adjourned.]
    [Prepared statement and response to written questions 
supplied for the record follow:]

                       STATEMENT OF JOHN C. DUGAN
                      Comptroller of the Currency
             U.S. Office of the Comptroller of the Currency

                           November 10, 2005

Introduction
    Chairman Shelby, Senator Sarbanes, and Members of the Committee, I 
appreciate this opportunity to discuss plans of the U.S. banking 
agencies to update and enhance our regulatory capital program in two 
fundamental ways: First, through the implementation of the 
``International Convergence of Capital Measurement and Capital 
Standards: A Revised Framework,'' generally known as the Basel II 
framework; and second, through revisions to our existing domestic risk-
based capital framework for banks not adopting Basel II, generally 
known as Basel I-A.
    The primary impetus for the agencies' work to revise existing risk-
based capital rules is to enhance the long-term safety and soundness of 
our banking system. While the U.S. banking industry continues to 
operate profitably, supervisors must ensure that regulatory capital 
rules remain relevant and appropriately address existing and emerging 
safety and soundness challenges. For our largest banks, the fundamental 
thrust of our efforts has been to develop a more risk sensitive 
regulatory capital system better suited to the complex operations and 
activities of these institutions. For banks not adopting Basel II, our 
primary goal is to increase the risk sensitivity of our risk-based 
capital rules without unduly increasing regulatory burden. Work in 
these areas is again moving forward as the result of agreement by the 
agencies, announced in a joint statement on September 30.
    The joint statement included a revised timeline for U.S. 
implementation of Basel II and a series of prudential safeguards to 
ensure that capital levels similar to those that exist in our largest 
banks today will be maintained over an extended transition period. The 
statement also highlighted our expectation that the rules implementing 
Basel II in the United States will be modified as necessary based on 
experience with the new framework during that transition period, and 
before the prudential safeguards expire.
    The joint statement reflected a consensus by all the U.S. agencies 
that implementation of the Basel II framework should move forward. Our 
agreement to do so was based on several key premises:

 First and foremost, the Basel II framework offers necessary 
    and appropriate improvements to address recognized flaws in the 
    existing risk-based capital regime for our largest, most complex 
    banks. Basel II will promote significant advances in risk 
    management that will benefit supervisors and banks alike and that 
    will enhance the safety and soundness regime under which the 
    largest institutions operate.
 Second, to achieve its intended purpose, the framework will 
    have to be thoroughly tested and almost certainly adjusted. The 
    recent quantitative impact study (QIS-4) of estimated Basel II 
    results in large U.S. banks produced significant dispersion of 
    results across institutions and portfolio types and suggested a 
    material reduction in aggregate minimum required capital. Apart 
    from the notice and comment process, however, additional agency 
    study of the Basel II framework itself will do little to resolve 
    those concerns. Indeed, without seeing live systems in operation--
    and subjecting them to supervisory scrutiny--we will not be able to 
    gain the level of comfort we ultimately must have in order to rely 
    on Basel II for regulatory capital purposes.
 Third, it is our intention to proceed deliberately, gaining a 
    better understanding of the effects of Basel II on bank risk 
    management practices and capital levels. Upcoming Basel II 
    rulemakings, therefore, will include a meaningful transition period 
    during which we can observe and scrutinize Basel II systems while 
    strictly limiting, through a system of simple and conservative 
    capital floors, potential 
    reductions in capital requirements. Based on the experience we gain 
    through supervisory oversight in the transition period, we will 
    incorporate any necessary revisions to the U.S. Basel II-based 
    rules before the transition period ends.

    Because we believe that regulations must be tailored to the size, 
structure, complexity, and risk profile of banking institutions, we 
expect mandatory application of Basel II to be limited to large complex 
institutions. However, we need meaningful but simpler improvements in 
our domestic risk-based capital rules for banks that will not be 
subject to Basel II. Our Basel I-A initiative is separate from but 
complementary to the Basel II rulemaking process, and it is important 
that the public be able to compare, contrast, and comment on definitive 
proposals for both Basel II and Basel I-A in similar timeframes. We 
believe that overlapping comment periods for these two rulemakings is a 
critical element of our on-going effort to assess the potential 
competitive effects of these proposals on the U.S. financial services 
industry.
    On this basis, the banking agencies agreed that it is both prudent 
and necessary to develop and issue a notice of proposed rulemaking 
(NPR) for Basel II implementation and to solicit comments from the 
public. In order to do this, however, prudential safeguards are an 
absolute necessity, and we recognize that further changes will take 
place through future rulemakings.

The Need for Basel II in the United States
    The implementation of Basel II in the United States remains 
controversial, requiring banks and supervisors to balance sometimes 
conflicting objectives regarding complexity of minimum capital 
requirements, regulatory burden, competitive equity, alignment of 
regulatory capital with better measures of risk, and recognition of 
marked improvements in risk management capabilities. A fair question, 
and one we have asked ourselves at various stages of this process is, 
``Given all the difficulties and uncertainties associated with Basel 
II, why move forward with it at all?'' While other sections of my 
testimony explain how we plan to go forward, I also understand the need 
to address why.
    The 1988 Basel Accord, also referred to as Basel I, established a 
framework for risk-based capital adequacy standards that has now been 
adopted by most banking authorities around the world. The U.S. agencies 
have applied rules based on the 1988 Basel Accord to all U.S. insured 
depository institutions. Although Basel I was instrumental in raising 
capital levels across the industry in the United States and worldwide, 
it became increasingly evident through the 1990's that there were 
growing weaknesses in Basel I. In particular, the relatively simple 
framework has become increasingly incompatible with the increased scope 
and complexity of the banking activities of our largest banking 
institutions. The crude risk-weighting mechanisms of Basel I bear 
little resemblance to the complex risk profiles and risk management 
strategies that larger banks are capable of pursuing. The 
misspecification of risk under Basel I creates inappropriate incentives 
and arbitrage opportunities that undermine supervisory objectives. And 
dealing with outdated and mismatched regulatory requirements is costly 
to banks.
    In response to these issues, the Basel Committee commenced an 
effort to move toward a more risk sensitive capital regime. As the OCC 
has noted in earlier hearings, we firmly support the objectives of the 
Basel Committee and believe that the advanced approaches of the Basel 
II framework--the advanced internal ratings-based approach (IRB) for 
credit risk and the advanced measurement approaches (AMA) for 
operational risk--constitute a sound conceptual basis for the 
development of a new regulatory capital regime for large 
internationally active banks. In a system in which some individual 
institutions hold well over $1 trillion in assets, the flaws of the 
current, overly simplistic risk-based capital system cannot be seen as 
merely superficial or inconvenient.
    It is important to understand that the supervisory benefits of 
Basel II are found not only in the increased risk sensitivity in 
regulatory capital requirements, but also in the significantly improved 
bank risk management systems required to generate them. As the front-
line supervisor for national banks, which hold nearly 70 percent of the 
Nation's banking assets, the OCC stands to gain significantly from 
implementation of those systems, not only from improved risk 
sensitivity of regulatory capital ratios, but also from the wealth of 
internal information and analyses that banks will provide us under 
Basel II. Banks will be better informed about the risks they face, and 
supervisors will have information about those risks from both an 
individual institution and industry perspective. Large banks have 
already made substantial investments in the development of Basel II 
systems. Without further guidance and proposed rules, however, progress 
toward Basel II standards will be severely limited.
    While clearly secondary to U.S. safety and soundness concerns, 
another important consideration is the need for internationally active 
banks to have similar capital regimes in the jurisdictions in which 
they operate. The benefits of global comparability in regulatory 
capital are not limited to level playing field considerations. Moving 
forward with Basel II also enhances internationally active banks' 
ability to interact on a meaningful and consistent basis with various 
supervisory authorities while improving how supervisors interact with 
one another. Without a common framework, our ability to gain useful 
information and cooperation from foreign supervisors would be severely 
constrained. We are very much aware that differences in the 
implementation details, including the timeline, can create significant 
challenges for banks operating in multiple jurisdictions. While some of 
these differences are 
unavoidable, the OCC and the other U.S. banking agencies will continue 
to work closely with foreign-based regulators to address these issues 
as they arise. The implementation of Basel II will ultimately serve to 
increase the dialogue and coordination among national supervisors and 
to enhance the level of cross-border cooperation for our largest banks.
    In short, the continued safety and soundness of our banking system 
demands that we move away from the current simplistic system to one 
that more closely aligns capital with risk. Put another way, doing 
nothing to change capital requirements would over time threaten the 
safety and soundness of the banking system, especially with regard to 
our largest banks that engage in increasingly complex transactions and 
operations and hold increasingly complex assets. In these largest 
banks, more closely aligning regulatory capital and risk management 
systems with actual risk is a conceptually sound and prudent way to 
move forward. That is the fundamental purpose of Basel II, and while 
the framework may require significant changes over time, it is moving 
in the direction required by safety and soundness concerns.
    That is the essential reason why I believe we should support the 
Basel II approach.

QIS-4 Results and Analysis
    In previous Congressional testimony, in Basel Committee 
deliberations, and in discussions with the industry and other 
supervisors, the OCC has repeatedly emphasized that reforms to our 
regulatory and supervisory structure must be adopted in a prudent, 
reflective manner, consistent with safety and soundness and the 
continued competitive strength of the U.S. banking system. In 
furtherance of those standards, the U.S. agencies conducted an 
extensive quantitative impact study, QIS-4, in late 2004 and early 
2005.
    It is well-known that QIS-4 helped us identify significant issues 
about Basel II implementation that have not been fully resolved. Even 
subsequent to additional agency analysis, the QIS-4 submissions 
evidenced both a material reduction in the aggregate minimum required 
capital for the QIS-4 participant population and a significant 
dispersion of results across institutions and portfolio types. One 
measure produced by QIS-4 is the estimated change in ``effective 
minimum required capital,'' which represents the change in capital 
components, excluding reserves, required to meet the 8 percent minimum 
total risk-based ratio. This measure is independent of the level of 
capital actually held by institutions and of their currently measured 
capital ratios. Aggregating over the QIS-4 participants, the decrease 
in effective minimum required capital compared to existing standards 
was 15 percent, with a median decrease of 26 percent. As noted above, 
the additional QIS-4 analyses also confirmed that dispersion in 
results--with respect to individual parameter estimates, portfolios, 
and institutions--was much wider than we anticipated or than we can 
readily explain. In particular, the agencies' additional analysis 
revealed a wide dispersion of results between institutions with respect 
to individual credit exposures and selected portfolios, even when 
controlling for differences in risk.
    The agencies are in the process of preparing a more detailed 
summary of results of our follow-up analyses of QIS-4 for public 
release and are now conducting meetings with participants to discuss 
observations about their particular submissions. There are, however, 
some broad observations I can make today about the apparent underlying 
causes of the significant reductions and wide dispersions in capital 
requirements in QIS-4:

 The single most important conclusion from our analysis is that 
    differences in results between banks and within portfolios 
    evidenced in QIS-4 submissions did not correspond directly to 
    identifiable differences in risk. Banks' current estimates of key 
    parameters in the IRB approach--probabilities of default, loss 
    given default, and exposure at default--fall well-short of the 
    level of reliability that will be necessary to allow supervisors to 
    accept those estimates for risk-based capital purposes.
 Closely related is the observation that institutions are still 
    at widely varying stages of development of the systems and 
    processes necessary to implement the Basel II framework. This 
    finding is not intended to be a criticism of bank implementation 
    efforts; banks have dedicated significant staff and budget 
    resources to Basel II. Rather, these development efforts have been 
    hindered by the absence of definitive rules or final guidance in 
    the United States. Consequently, the full impact of Basel II 
    implementation remains to be seen, as do potential ramifications 
    for the U.S. banking system.
 Basel II results appear to be materially influenced by the 
    prevailing economic cycle, which suggests significant fluctuations 
    in capital requirements under the framework over the course of 
    economic cycles.

    In short, the QIS-4 results and the inevitable questions they raise 
are sources of concern for the banking agencies. The process for 
implementing Basel II as established in the September 30 joint 
statement is designed to provide the OCC and other agencies a complete 
understanding of the framework's implications for the banking system. 
We have concluded that some of the weaknesses identified in QIS-4 are 
attributable to the fact that no ``live'' Basel II systems have been 
built--in large part because we have not yet fully specified all the 
requirements for such a system. We also believe that certain of the 
concerns identified in QIS-4 will only be fully understood and resolved 
as the Basel II framework is implemented through a final rule, final 
supervisory guidance, and rigorous examiner scrutiny.

The Need to See Systems in Operation
    QIS-4 was a voluntary, ``best efforts'' undertaking by participant 
banks. The actual implementation of Basel II systems will be preceded 
by stringent qualification assessments and, assuming qualification, 
will be subject to regular on-site review by examination staff and 
other subject matter experts. We expect to see less dispersion in 
results for similar risks as banks more fully develop IRB and AMA 
compliant methodologies, supported by enhanced data systems and subject 
to rigorous 
ongoing supervisory oversight and disclosure requirements. We remain 
convinced that supervisors and the industry will both eventually reap 
significant rewards--in the form of better risk management and better 
information about risk--when Basel II systems are built and operating.
    It became apparent as we analyzed QIS-4 results that we have 
reached a point where more study of the conceptual underpinnings of 
Basel II will yield little additional practical benefit. Rather, the 
questions that we as supervisors still have about Basel II--and there 
are several that are extremely important--can only be answered by 
continuing to move toward implementation. Given the obstacles that have 
not yet been cleared, though, I firmly believe that the only 
responsible way to do that is in a carefully controlled manner, with 
strong safeguards, during a significant transition period to see the 
systems in actual practice.
    We see only one pragmatic solution to resolve this inherent 
stalemate between our insistence on understanding the effects, and 
allowing for and encouraging the development of systems that will allow 
us to gain that understanding. That is to proceed with the next steps 
of Basel II implementation, but with a series of prudential safeguards 
in place until we can observe approved Basel II systems in actual 
operation and subject them to supervisory scrutiny. Only then will it 
be possible to judge whether Basel II is operating as intended and to 
make adjustments as necessary to ensure that it does.

Transition Provisions
    The revised implementation plan announced by the agencies on 
September 30 includes several key elements that allow for the progress 
we believe is necessary, over time, for risk management and supervisory 
purposes, while strictly limiting reductions in risk-based capital 
requirements that might otherwise result from systems that have not 
been proven.
    The first element is a one-year delay in initial implementation, 
relative to the timeline specified by the Basel II framework. As a 
result, the ``parallel run,'' which is the prequalification period 
during which a bank operates IRB and AMA systems but does not derive 
its regulatory capital requirements from them, will be in 2008. The 
parallel run period, which will last at least four quarters but could 
be longer for individual institutions, will provide the basis for the 
OCC's initial qualification determination for national banks to use 
Basel II for regulatory risk-based capital purposes. Following initial 
qualification, a minimum 3-year transition period would apply during 
which reductions in each bank's risk-based capital would be limited. 
These limits would be implemented through floors on risk-based capital 
that will be simpler in design and more conservative in effect than 
those set forth in Basel II. For banks that plan to implement the Basel 
II framework at the earliest allowable date in the United States, we 
expect to propose the following timetable and transitional 
arrangements:



------------------------------------------------------------------------
    Year                       Transitional Arrangement
------------------------------------------------------------------------
       2008   Parallel Run
------------------------------------------------------------------------
       2009   95 percent floor
------------------------------------------------------------------------
       2010   90 percent floor
------------------------------------------------------------------------
       2011   85 percent floor
------------------------------------------------------------------------


    The OCC will assess national banks' readiness to operate under 
Basel II-based capital rules consistent with the schedule above and 
will make decisions on a bank-by-bank basis about termination of the 
floors after 2011.
    We also intend to retain the prompt corrective action (PCA) and 
leverage capital requirements in the proposed domestic implementation 
of Basel II. During the several years in which those provisions have 
complemented our basic risk-based capital rules, U.S institutions have 
thrived while building and maintaining strong capital levels--both 
risk-based and leverage. This capital cushion has proved effective not 
only in absorbing losses, but also in allowing banks to take prudent 
risks to innovate and grow.
    I have mentioned that the floors we intend to apply during the 
transition period will be simpler in design and more conservative in 
effect than those set forth in Basel II. I expect PCA requirements to 
play a significant role in the floor requirements. For example, in 
order to be ``well-capitalized'' for PCA purposes, a Basel II bank in 
2009 (subject to a 95 percent floor) would be required to have a total 
risk-based capital ratio of at least 10 percent, calculated under non-
Basel II rules but with a 5 percent reduction in risk-weighted assets. 
The bank would also have to meet the 10 percent total risk-based 
capital threshold on the basis of its Basel II results, with similar 
dual calculations applying to the 6 percent well-capitalized threshold 
for the Tier 1 risk-based capital ratio. PCA thresholds for the 
leverage ratio would of course also remain in place as they are today.
    While we intend to be true to the timelines above, we also expect 
to make further revisions to U.S. Basel II-based rules if necessary 
during the transition period (that is, before the system-wide floors 
terminate in 2011), on the basis of observing and scrutinizing actual 
systems in operation during that period. That will allow us to evaluate 
the effectiveness of the Basel II-based rules on the basis of real 
implementation and to make appropriate changes or corrections while the 
prudential transition safeguards are still in effect. Of course, any 
future revisions will also be subject to the full notice and comment 
process, and we expect to look to that process where necessary to help 
resolve difficult issues.
    The revised timeline detailed in the September 30 joint statement 
also makes possible greater coordination between the Basel II process 
and the on-going effort to revamp risk-based capital rules governing 
banks not adopting Basel II. The agencies expect that proposed rules 
for the U.S. implementation of Basel II will be available in the first 
quarter of 2006. As discussed in more detail below, the banking 
agencies are also jointly seeking comments on a number of possible 
revisions to our existing risk-based capital rules for banks not 
adopting Basel II. After consideration of public comments on that 
proposal, the agencies expect to move forward with a notice of proposed 
rulemaking on Basel I-A in 2006. As I have made clear previously, it is 
imperative that there be substantial overlapping comment periods on the 
Basel II and Basel I-A proposed rules. This will permit regulators and 
industry participants to directly compare the two proposals and assess 
competitive effects and other issues in the development of comments.

Basel I-A
    On October 20, the agencies jointly published in the Federal 
Register an advance notice of proposed rulemaking (ANPR) seeking 
comments on suggested broad revisions to our existing domestic risk-
based capital rules, which are based on the 1988 Basel Accord. I 
believe the ANPR is a good first step in the direction of improving the 
risk-based capital rules that apply to U.S. banks without the enormous 
expense and massive complexity of the Basel II framework.
    The modifications we are considering would:

 Increase the number of risk-weight categories to which credit 
    exposures may be assigned;
 Expand the use of external credit ratings as an indicator of 
    credit risk for externally rated exposures;
 Expand the range of collateral and guarantors that may qualify 
    an exposure for a lower risk weight;
 Use loan-to-value ratios, credit assessments, and other broad 
    measures of credit risk for assigning risk weights to residential 
    mortgages;
 Modify the credit conversion factor for various commitments, 
    including those with an original maturity of under 1 year;
 Require that certain loans 90 days or more past due or in a 
    nonaccrual status be assigned to a higher risk weight category;
 Modify the risk-based capital requirements for certain 
    commercial real estate exposures;
 Increase the risk sensitivity of capital requirements for 
    other types of retail, multifamily, small business, and commercial 
    exposures; and
 Assess a risk-based capital charge to reflect the risks in 
    securitizations backed by revolving retail exposures with early 
    amortization provisions.

    Our primary goal in this rulemaking effort is to increase the risk 
sensitivity of our domestic risk-based capital rules without unduly 
increasing regulatory burden. This is no small challenge, and we cannot 
easily accomplish that goal without substantial input from the public. 
In crafting the current proposal, the agencies drew from discussions 
with the banking industry, Congress, and our experiences in supervising 
the current risk-based capital regime. It is important to acknowledge 
that much important work on this proposal lies ahead. While some of the 
modifications the ANPR presents are well-defined, there are some areas 
that are not specified in great detail at this time. We are looking to 
commenters to provide additional views and information on current risk 
management practices to help refine these areas. So, I am eager to hear 
from the industry and other interested parties, and I hope this public 
comment process will begin a fruitful dialogue that will lead to more 
definitive proposals for a more risk sensitive regime.
    We recognize that a number of banks and industry groups are 
concerned that banks operating under Basel II might gain a competitive 
edge over banks not governed by the Basel II framework. That issue will 
remain in the forefront as we more fully develop any proposals that 
might stem from the Basel I-A ANPR as well as proposals for Basel II 
implementation. It is almost a certainty that the level of risk 
sensitivity we hope to achieve under Basel II is not possible in a 
simpler risk-based capital regime. However, we need to be very mindful 
of competitive equity issues, and we will endeavor to reduce gaps 
between the two frameworks as much as possible given our overarching 
priority to ensure that both frameworks move in the direction of 
greater risk sensitivity. That will require, among other things, an 
assessment of the quantitative effects of the Basel I-A proposals as 
they become more fully developed. It is also critical for regulators 
and interested parties to be able to review and compare definitive 
proposals for Basel II and for other domestic capital revisions within 
the same general timeframes.

Conclusion
    The overarching challenge we face is to improve on the simplistic 
Basel I risk-based capital regime. That regime is a poor arbiter of 
risks being taken by banks, insufficient to the task of monitoring risk 
in large, complex financial institutions, and long overtaken by events 
in the marketplace. It is also a source of inefficiency in the 
financial system. What we have learned through the development of Basel 
II is that for institutions that have the scale and financial capacity 
to do so, we can and should establish high standards of risk management 
that can be used to improve the alignment of regulatory capital with 
risk. Our Basel I-A efforts embody our belief that we can and should do 
better in defining capital requirements for the vast majority of 
national banks without massive complexity or enormous expense.
    We are committed to improving risk sensitivity of the risk-based 
capital rules for all institutions, but doing so in a way that is 
tailored to the size, structure, complexity, and risk profile of the 
institution, and that ensures safety and soundness. For the complex 
operations of our largest globally active national banks, we believe 
the Basel II framework holds great promise, and we remain committed to 
the next steps of implementing it in the United States. For the vast 
majority of national banks that will not use Basel II, we believe that 
the Basel I-A proposal introduces enhancement in the risk sensitivity 
of regulatory capital without unduly increasing regulatory burden.
    We have undertaken this task with full awareness of the challenges 
ahead. The OCC would not be pursuing these proposals if we did not 
believe they would take the industry and us in the direction of not 
only better risk-based capital calculations, but also better risk 
management, and even more fundamentally, a stronger and safer banking 
system.
                               ----------
                PREPARED STATEMENT OF SUSAN SCHMIDT BIES
       Governor, Board of Governors of the Federal Reserve System
                           November 10, 2005

    Chairman Shelby, Senator Sarbanes, and Members of the Committee on 
Banking, Housing, and Urban Affairs, I thank you for the opportunity to 
join my colleagues from the other Federal banking agencies to discuss 
the current status of Basel II in this country, as well as the status 
of proposed amendments to our existing Basel I-based capital rules.
Introduction
    The Federal Reserve considers the maintenance of strong and stable 
financial markets as an integral part of our responsibility and 
critically related to safety and soundness of the participants in those 
markets. Financial stability contributes to sustained economic growth 
by providing an environment in which financial institutions, 
businesses, and households can conduct their business with more 
certainty about future outcomes. Part of maintaining a strong financial 
system is ensuring that banking organizations operate in a safe and 
sound manner with adequate capital cushions that appropriately support 
the risks they take.
    As many of you are aware, there have been two major developments 
within the past 6 weeks regarding U.S. regulatory capital requirements 
that apply to banking institutions. First, on September 30, the U.S. 
banking agencies announced their revised plan for the implementation of 
the Basel II framework in the United States. Second, the agencies 
published for comment an advance notice of proposed rulemaking (ANPR) 
pertaining to amendments to the existing Basel I-based capital rules 
(the amended Basel I). Taken together, these proposals on Basel II and 
the amended Basel I represent substantial revisions to the regulatory 
risk-based capital rules applied to U.S. banking institutions, from the 
very largest to the smallest. From the Federal Reserve's perspective, 
these two initiatives, when implemented successfully, should produce a 
much-improved regulatory capital regime in the United States that 
enhances safety and soundness. The Federal Reserve considers the 
ongoing discussion between the Congress and the U.S. banking agencies--
and, of course, with the banking industry and members of the public--to 
be critical to the success of both sets of proposals.
Reasons for Pursuing Basel II
    We have all witnessed the substantial changes in the U.S. banking 
industry over the past decade, including growth in size and geographic 
scope, expansion of activities, development of new instruments and 
services, and greater use of technology. As a result, we have seen the 
rise of very large entities with large geographic reach operating in 
many lines of business and engaging in complex and sophisticated 
transactions. The largest institutions have moved away from the 
traditional banking strategy of holding assets on the balance sheet to 
strategies that emphasize redistribution of assets and actively 
managing risks. These dramatic changes to the risk profiles of many 
banking organizations have only accelerated with the continued 
evolution of many, often complex, financial tools, such as 
securtitizations and credit derivatives.
    Additionally, risk-management techniques employed by many banking 
organizations continue to change, improve, and adapt to the ever-
changing financial landscape. For instance, operational risk was not 
part of our risk-management thinking 10 years ago, but tools to 
identify, measure, and manage it are now becoming prevalent. Also, the 
lines between the banking book and the trading book have blurred 
significantly and organizations continue to move resources and products 
to optimize earnings and manage risks. And finally, global competition 
has intensified significantly, as the ability of customers to choose 
from a variety of local and international banking firms, as well as 
nonbank competitors, has increased.
    While the current Basel I-based rules have served us well for 
nearly two decades, they are simply not appropriate for identifying and 
measuring the risks of our largest, most complex banking organizations. 
Basel I, even when periodically amended, must be straightforward enough 
for even the smallest banking organizations to implement with relative 
ease. Thus, the categories of risk used to determine capital are very 
broad and are intended to capture the ``average'' risk levels across 
the banking system for that generic exposure.
    Large financial institutions tend to manage risk in more proactive 
ways, and are able to take advantage of new innovations in financial 
instruments to hedge, sell, or take on risk exposures to support their 
business strategies and profitability targets. As a result, they are 
able to remove balance sheet exposures for risks where they feel 
regulatory capital is set too high, and thereby reduce minimum 
regulatory capital. Smaller organizations generally do not have the 
risk-management systems or scale of transactions to make these 
practices economically viable.
    While the balance sheet focus of Basel I is appropriate for most 
banking organizations, the largest organizations have significant 
exposures off the books, and these risk exposures need to be considered 
explicitly in determining minimum regulatory capital for these 
sophisticated organizations. Large organizations are increasingly 
gravitating toward fee-based revenue streams. This is due to 
securitizations of loan portfolios that retain the responsibility of 
servicing the loans, buying and selling financial instruments for 
customers, and growth in business lines where fees are generated by 
transactions and account processing. These activities have little 
exposure shown on the balance sheet at a moment in time, but failure to 
operate complex systems and negotiate complex financial deals in a 
sound manner can lead to large loss exposures given the volume of 
activity that runs through the line of business. They also use 
sophisticated models to manage credit, market, and interest rate risks. 
Poor data integrity, model reliability or lack of sufficient controls, 
can create losses when management action relies on the faulty results 
of decision models.
    Finally, the complexity of these organizations makes it more 
difficult for executive management to view risk in a comprehensive way, 
both in terms of aggregating similar and correlated risks, but also 
identifying potential conflicts of interest between the growth of a 
line of business and the reputation, legal and compliance risks of the 
firm as a whole, In recent years, large financial institutions have 
reported losses from breaks in these operating controls that in some 
cases have exceeded those in credit or market risk.
    The Basel II framework should improve supervisors' ability to 
understand and monitor the risk taking and capital adequacy of large 
complex institutions, thereby allowing regulators to address emerging 
problems more proactively. It should also enhance the ability of market 
participants, through public disclosures, to evaluate the risk 
positions at those institutions by providing much better risk measures. 
The advanced approaches under Basel II, which include the advanced 
internal ratings-based approach (or A-IRB) for credit risk and the 
advanced measurement approaches (or AMA) for operational risk, offer 
particularly good improvements in terms of risk sensitivity, since they 
incorporate advanced risk-management processes already used today by 
best-practice institutions.
    Indeed, the expected improvements in risk measurement and risk 
management form the core of our reasons for proposing Basel II in the 
United States. Its advanced approaches create a rational link between 
regulatory capital and risk management. Under these approaches, 
institutions would be required to adopt a set of quantitative risk-
measurement and sophisticated risk-management procedures and processes. 
For instance, Basel II establishes standards for data collection and 
the systematic use of the information collected. These standards are 
consistent with broader supervisory expectations that high-quality risk 
management at large complex organizations depends upon credible data. 
Enhancements to technological infrastructure--combined with detailed 
data--will, over time, allow firms to better track exposures and manage 
risk. The emphasis in Basel II on improved data standards should not be 
interpreted solely as a requirement to determine regulatory capital 
standards, but rather as a foundation for more advanced risk-management 
practices that would strengthen the value of the banking franchise. But 
while the new framework would, in our view, provide useful incentives 
for institutions to accelerate the improvement of risk management, we 
believe in most areas of risk management institutions would continue to 
have the choice among which methods they employ.
    Thus, from a safety and soundness regulatory perspective, for these 
large, complex financial organizations, regulators and market 
participants need the information provided by the advanced framework of 
Basel II.

Recent Developments with Basel II
    The Federal Reserve considers the agencies' September 30 
announcement relating to Basel II a good outcome and an example of 
successful interagency cooperation. As you may recall, in April of this 
year, the agencies announced jointly their reaction to initial results 
of a fourth quantitative impact study pertaining to Basel II, known as 
QIS-4. As the April statement indicated, we were concerned about 
results from QIS-4 that showed a wider dispersion and a larger overall 
drop in minimum regulatory capital requirements for the QIS-4 
population of institutions than the agencies had initially expected. 
The initial QIS-4 results prompted the agencies to delay issuance of a 
notice of proposed rulemaking (NPR) for Basel II in order to conduct 
further analysis of those results and their potential impact. The 
agencies' reaction to the initial QIS-4 results, deciding to take 
additional time to understand more fully the information provided by 
the QIS-4 institutions, is an indicator of how seriously we are taking 
Basel II implementation.
    During the summer, the U.S. agencies conducted additional analysis 
of the information reported in QIS-4. That analysis is for the most 
part complete. Based on the new knowledge gained from the additional 
QIS-4 analysis, the U.S. agencies collectively decided to move ahead 
with an NPR but adjust the plan for U.S. implementation of Basel II. 
Adjustments to the plan include extending the timeline for 
implementation and augmenting the transitional floors, which should 
provide bankers and regulators with more experience with Basel II 
before it is fully implemented in the United States. In addition, the 
agencies stated specifically in our joint press release that after 
completing a final rule for Basel II, we intend to revisit that rule 
prior to the termination of the transitional floors. That is, we expect 
to perform additional in-depth analyses of the Basel II minimum capital 
calculations produced by institutions during the parallel run and 
transitional floor periods before we move to full implementation 
without floors. This is consistent with the overall process we have 
laid out for implementing Basel II. We want to ensure that the minimum 
regulatory capital levels for each institution and in the aggregate for 
the group of Basel II banks provide an adequate capital cushion 
consistent with safety and soundness.
    Probably the most important thing we learned from the QIS-4 
analysis is that progress is being made toward developing a risk-
sensitive capital system. In terms of the specifics of the analysis, we 
learned that the drop in QIS-4 capital was largely due to the favorable 
point in the business cycle when the data were collected. While the 
previous QIS-3 exercise was conducted with data from 2002, a higher 
credit loss year, QIS-4 reflected asset portfolio, risk management 
information and models during one of the best periods of credit quality 
in recent years. We learned that the dispersion was largely due to 
varying risk parameters used by the institutions, which was permissible 
in the QIS-4 exercise, but also due to portfolio differences. That is, 
banks have different approaches to risk-management processes, and their 
models and databases reflect those differences.
    We also learned that some of the data submitted by individual 
institutions was not complete; in some cases banks did not have 
estimates of loss in stress periods--or used estimates that we thought 
were not very sophisticated--which caused minimum regulatory capital to 
be underestimated. Based on the results of QIS-4, the Federal Reserve 
recognizes that all institutions have additional work to do. In our 
view, the findings did not point to insurmountable problems, but 
instead identified areas for future supervisory focus. In that way, the 
analysis was critical in providing comfort to enable us to move 
forward.
    It is also helpful to remember that the QIS-4 exercise was 
conducted on a best-efforts basis. It was just one step in a 
progression of events leading to adoption of the Basel II framework. We 
certainly expect that as we move closer to implementation, supervisory 
oversight of the Basel II implementation methodologies by our 
examination teams would increase. Indeed, during the qualification 
process we expect to have several additional opportunities to evaluate 
institutions' risk-management processes, models, and estimates--and 
provide feedback to the institutions on their progress. So while the 
QIS-4 results clearly provided a much better sense than before of the 
progress in implementing Basel II and offered additional insights about 
the link between risks and capital, QIS-4 should not be considered a 
complete forecast of Basel II's ultimate effects. It was a point-in-
time look at how the U.S. implementation was progressing.
    Institutions participating in QIS-4 put a lot of time and effort 
into assisting with the QIS-4 analysis. For that reason, we owe it to 
the institutions to provide feedback prior to engaging in a detailed 
public discussion of the findings. Those feedback sessions, a full 
interagency effort involving an interagency agreed-upon presentation of 
the results, are now underway and we expect them to be largely 
completed by the end of this month. The agencies plan to release a 
public document describing our findings shortly after these sessions 
are completed, we hope by the end of the year.

Proposed Next Steps in the Basel II Process
    I would now like to describe some possible next steps in the Basel 
II process. To be clear, these thoughts represent our best estimates at 
this time and could change, given the extensive opportunity for public 
comment and additional interagency discussions to come. But I thought 
it would at least be helpful to offer the Federal Reserve's 
perspective.
    First, we support the idea of finishing an NPR on Basel II and 
related supervisory guidance as soon as possible, which right now looks 
to be in the first quarter of 2006. We believe that the best way to 
further augment our understanding of the impact of Basel II is to issue 
the NPR and hear reaction from the Congress, the industry, and the 
public. In addition, we are interested in issuing the NPR and related 
supervisory guidance as soon as possible so that bankers can have a 
better idea of supervisory expectations relating to Basel II. The NPR 
will help bankers identify the areas where they need to strengthen 
their risk-measurement processes as they continue to prepare for 
adoption of Basel II.
    After the end of the NPR comment period, the agencies plan to 
review the comments and decide more specifically on how to move 
forward. The agencies would then develop a strategy for issuing a final 
rule on Basel II, of course taking into account comments received. Once 
the final rule is issued, those institutions moving to Basel II would 
complete preparations to move to a parallel run, a period in which 
minimum regulatory capital measures under both Basel II and Basel I 
will be calculated. Under the current timeline, the parallel run would 
start in January 2008.
    The parallel run period, which is intended to last for four 
continuous quarters, should provide us with additional key information 
about the expected results for Basel II on a bank-by-bank basis, as 
well as the level of bank preparedness to operate under Basel II. Once 
an institution conducts a successful parallel run, the relevant primary 
Federal supervisor would then confirm the bank's readiness and give 
permission for the institution to move to the first initial phase of 
adoption, into the initial floor period. It is only after an 
institution has operated to the primary supervisor's satisfaction in 
the parallel run and each of the 3 years of floors that it would be 
allowed to have its minimum regulatory capital requirements determined 
by Basel II with no floors.
    During U.S. implementation of Basel II, if at any stage in the 
process we see something that concerns the banking agencies, we will 
reassess and propose amendments to relevant parts of the framework. The 
agencies have already decided to embed in the planned timeline the 
possibility for a later revision to the initial Basel II rule (before 
the floors are removed), since it is expected that new information 
provided in the parallel run and floor years might point to a need for 
adjustments to that initial rule. This is entirely consistent with the 
path we have taken in the past regarding Basel I, to which there have 
been more than twenty-five revisions since 1989. The Federal Reserve 
considers all of the planned safeguards and checks and balances to be 
sufficient for Basel II to be implemented in the United States 
effectively, and with no negative impact on safety and soundness or the 
functioning of banking markets.

Proposed Amendments to Basel I
    As I noted, the Basel II proposal is not the only minimum 
regulatory capital proposal being contemplated by the U.S. banking 
agencies. We have issued an ANPR for amendments to Basel I that is 
another important initiative in our efforts to update regulatory 
capital rules. The regulatory capital rules to be amended by the ANPR 
would apply to thousands of banking institutions in the United States, 
while the Basel II proposal would likely only apply to 10 to 20 at 
inception. The agencies are focusing considerable attention on the 
potential interplay between the proposed Basel II rules and the 
proposed Basel I amendments in order to ensure that the goals for each 
are achieved.
    The Federal Reserve's statement pertaining to the release of the 
ANPR highlighted that the revisions are intended to align risk-based 
capital requirements more closely with the risk inherent in various 
exposures. The ANPR relates, in part, to some long-standing issues in 
our current capital rules that have been identified (such as requiring 
capital for short-term commitments). We also noted that the amended 
Basel I is intended to mitigate certain competitive inequalities that 
may arise from the implementation of Basel II rules (such as lowering 
the risk weight for some residential mortgage exposures). In 
considering these possible revisions, the U.S. agencies are seeking to 
enhance the evaluation of bank portfolios and their inherent risks 
without undue complexity or regulatory burden. In issuing the ANPR, an 
advance notice, the agencies are emphasizing that views are still being 
developed and additional comment from the banking industry and other 
interested parties would be both beneficial and welcome before we move 
forward. We are intentionally leaving a number of areas open in order 
to solicit a broad range of comments before we narrow down the range of 
possibilities.
    The U.S. banking agencies have identified over the past several 
years a number of issues that need to be addressed within our current 
Basel I rules. The development of Basel II-based rules also creates the 
need for the U.S. agencies to amend the current rules in order to 
address issues relating to competitive impact. While we view that 
impact as limited, we want to ensure that institutions not moving to 
Basel II have equal opportunities to pursue business initiatives and 
are not placed at a competitive disadvantage or otherwise adversely 
affected. That is why we are being very careful to analyze the 
potential results of these two efforts in tandem, and asking for the 
Congress, the industry, and others to provide comments on the potential 
effects of both initiatives.
    We believe that the revisions to Basel I-based rules should benefit 
most institutions by better reflecting current risk exposures in 
regulatory capital requirements at little additional burden. Naturally, 
regulatory capital requirements are usually not the binding constraint 
for banking organizations. Nearly all institutions hold capital in 
excess of the minimum required regulatory ratios, in many cases several 
percentage points above, to satisfy rating agencies, debtholders and 
shareholders, and counterparties in the market. By the same token, 
pricing in the banking industry is not driven by regulatory capital, 
but rather, as most would intuitively assume, by supply and demand and 
business decisions made by bankers. But we think regulatory capital can 
act as a useful gauge of risk-taking, even though it would not be the 
deciding factor in business decisions.
    With respect to the proposals for amended Basel I, as well as Basel 
II, the Federal Reserve fully supports retention of the existing prompt 
corrective action (PCA) regime, which the Congress put in place more 
than a decade ago, as well as existing leverage requirements. In 
addition to the safeguards planned for initiatives being discussed 
today, we at the Federal Reserve take comfort that the PCA and leverage 
requirements will continue to provide a level of protection for 
depositors, consumers, and the financial system as a whole. These 
regulations help to ensure a minimum level of capital at individual 
institutions and in the aggregate that we consider to be absolutely 
vital to the health of our banking system and the economy more broadly.

Importance of the Rulemaking Process
    At the Federal Reserve--indeed, I think I can say among all the 
U.S. banking agencies--we understand and respect the rulemaking process 
and the legal requirements for implementing regulatory revisions. This, 
of course, includes comment periods for each of our regulatory capital 
proposals and transparency in our overall process. We encourage a 
healthy debate about the agencies' proposed initiatives--including the 
recently revised timeline for Basel II. We look forward to continuing 
to engage the industry, the Congress, fellow supervisors, and others in 
a discussion about what effects the Basel II framework and the Basel I 
revisions might have on our banking system. The proposals are intended 
to provide the right incentives for bankers, but if the proposals do 
not achieve this goal, we want to know why. In the past, when we have 
been provided with well-documented and convincing reasons for making a 
change to the Basel II framework or the U.S. implementation process, we 
have heeded those arguments. We expect to have the same posture 
regarding comments on the proposed Basel I amendments. We continue to 
recognize that vigorous discussion and debate produce a much better 
product. And we expect to remain vigilant about the potentially 
unintended and undesired consequences, particularly those that might 
affect a certain class of banks.
    Additionally, I would like to emphasize that from my perspective 
the U.S. agencies continue to work well with one another on these 
regulatory capital proposals in a general environment of cooperation 
and good will. While the U.S. agencies naturally disagree on certain 
policy matters and implementation issues from time to time, we at the 
Federal Reserve are pleased with the outcomes to date and recognize 
that all 4 agencies are making considerable contributions to the 
overall effort.

Dialogue with the Industry
    The extension of the U.S. timeline for Basel II, along with the 
ongoing proposals for amended Basel I, obviously present some 
challenges for U.S. institutions. We will continue our efforts to 
ensure that we hear about these challenges and do our best to assist 
institutions in meeting them. First of all, bankers must keep track of 
the latest proposals and understand what they could mean for their own 
institutions. For those institutions looking to prepare for adoption of 
Basel II, making the manifold upgrades in risk-measurement and -
management systems--not the least of which is developing credible 
databases--is even more difficult, especially since complete and final 
supervisory expectations have yet to be released. But we certainly hope 
that institutions do not lose momentum based on the revised timeline 
for Basel II; indeed, that timeline reflects our assessment of the work 
that still lies ahead.
    While institutions might be challenged to move forward in certain 
areas until the Basel II NPR and its associated supervisory guidance is 
issued, we still believe that they can make strides in other areas. For 
one, the agencies all along have emphasized the importance of 
institution-specific implementation plans, which include gap analyses, 
clearly defined milestones, and remediation plans. In other words, we 
think that institutions could now continue development of the corporate 
governance surrounding each institution's efforts in Basel II 
implementation and focus on their individual implementation processes. 
In addition, supervisors have begun to discuss individual QIS-4 results 
with each participant; these discussions include specific feedback 
about the institution's results and some general peer comparisons.
    Additionally, we do recognize that the recent update to U.S. 
implementation plans could generate some challenges for U.S. 
institutions as they try to implement Basel II worldwide, as well as 
for foreign banks operating in the United States. Overall, we think 
these challenges are manageable and we can facilitate solutions to them 
during the implementation process. While not downplaying potential 
challenges, the U.S. agencies, in deciding to adjust implementation 
plans, thought it was important to ensure that implementation in the 
United States be conducted in a prudential manner and without 
generating competitive inequalities in our banking markets. As before 
the September 30 announcement, we continue to work with institutions 
and foreign supervisors to minimize the difficulties in cross-border 
implementation. Our support includes extensive discussion with other 
countries in the Basel Accord Implementation Group, as well as more 
informal, bilateral discussions with institutions and foreign 
supervisors. Our view is that these cross-border issues do not 
necessarily represent fundamentally new problems; while requiring some 
work, these challenges are manageable. It is also useful to point out 
that all Basel member countries have their own rollout timelines and 
national discretion issues, not just the United States--which is 
entirely appropriate. In order to assist institutions in resolving 
their cross-border challenges, we are eager to hear specifics from 
institutions so that we can develop targeted solutions.

Conclusion
    Mr. Chairman, in my remarks today I have described the Federal 
Reserve's views on suggested changes to the current regulatory risk-
based capital regime, namely the proposals for Basel II and amended 
Basel I. I have outlined the need for change, the work completed to 
date, and some of the lessons learned. In our view, recent exercises 
such as QIS-4 have served as useful indicators of the progress being 
made and the direction needed for these initiatives on regulatory 
capital requirements. QIS-4 was part of an extended series of 
activities to ensure that the suggested regulatory capital revisions 
are implemented in an appropriate and prudent manner. From the Federal 
Reserve's perspective, we should continue to move forward with the 
activities I described, while seeking comment and listening to feedback 
at every stage.
    Our support for Basel II stems from the belief that it would 
provide a much better measure of minimum regulatory capital at the 
largest, most complex institutions, aligning capital with risks to 
which these institutions are exposed. We also believe that Basel II 
would bring about substantial improvements in risk management to those 
institutions. At the same time, amending Basel I for the vast majority 
of banking institutions in the United States could improve the 
reflection of risks in Basel I-based rules without much additional 
burden. Taken together, these initiatives should ensure adequate 
minimum capital cushions, allow fair competition, maintain safety and 
soundness, and enhance financial stability.
    I am pleased to answer your questions.
                               ----------

                 PREPARED STATEMENT OF DONALD E. POWELL
            Chairman, Federal Deposit Insurance Corporation
                           November 10, 2005

    Chairman Shelby, Senator Sarbanes, and Members of the Committee, it 
is a pleasure to appear before you today on behalf of the Federal 
Deposit Insurance Corporation to discuss current developments regarding 
Basel II.
    As you know, Basel II is an international effort to create 
standards for capital requirements that would allow banking 
institutions to use internal estimates of credit and operational risk 
to determine their minimum risk-based regulatory capital requirement. 
Basel II is intended to be a framework that is more risk-sensitive and 
one that promotes a more disciplined approach to risk management at our 
largest banks. Basel II has been developed to respond to concerns that 
the regulatory arbitrage opportunities available under Basel I threaten 
the adequacy of the regulatory capital buffer needed to ensure 
financial system stability. It is important to remember that an 
overarching objective of Basel II is to reinforce capital adequacy 
standards by better aligning minimum capital requirements with risk and 
thereby prevent an erosion of the aggregate level of capital in 
individual banks and the banking system.
    The FDIC supports these broad goals and is actively engaged in the 
regulatory process to develop a new capital framework for the United 
States. As the U.S. banking and thrift agencies move forward to 
implement Basel II, we must ensure that the new capital framework does 
not produce unintended consequences, such as significant reductions in 
overall capital levels, the creation of substantial new competitive 
inequities between certain categories of insured depository 
institutions, or an expansion of the Federal banking safety net by 
blurring the regulatory lines between banks and holding companies.
    About 6 weeks ago, the U.S. agencies announced a plan for moving 
forward with the implementation of Basel II in the United States. I 
participated in and support that plan because Basel II has the 
potential to represent positive change in capital regulation for our 
largest banks. Basel II clearly requires a more sophisticated approach 
to risk measurement by the adopting banks. At the same time, however, 
the most recent quantitative impact study, QIS-4, showed both a very 
large reduction in capital requirements for many banks, and large 
differences in capital requirements for what appeared to be identical 
risks. All the agencies agreed that the results of the impact study 
were unacceptable and that more work remains to be done to address 
these concerns.
    QIS-4 was a comprehensive effort drawing upon data submitted by 26 
of the largest U.S. banking organizations designed to provide the 
agencies with an improved understanding of how Basel II affects minimum 
required capital at the industry, institution, and portfolio level. A 
comprehensive review of the QIS-4 results, conducted over the spring 
and summer of this year, raised many questions and concerns. The 
agencies' preliminary review of QIS-4 data indicates that, relative to 
Basel I, minimum risk-based capital requirements under Basel II will be 
reduced for most of the banking organizations in the study--
substantially in many cases--to levels that the FDIC does not consider 
commensurate with the risks to which these institutions are exposed. 
Further, the results indicate a wide dispersion of results at both the 
banking organization and portfolio or business line level, including 
material differences in capital requirements for identical, or 
virtually identical, credit exposures.
    These QIS-4 results pose a dilemma for the agencies. QIS-4 suggests 
that the present framework will produce unacceptable capitalization 
outcomes. Yet, committing to specific changes to the framework at this 
time, without the benefit of further experience and industry systems 
development, would be premature. That is why, on September 30, 2005, 
the agencies announced that we will move forward with a Basel II Notice 
of Proposed Rulemaking (Basel II NPR) that includes additional time for 
bank systems development with added prudential safeguards. Those 
safeguards include more conservative risk-based capital floors, and a 
clear signal that changes to the framework will be made based on 
further experience. Ultimately, changes to the Basel II framework are 
likely to be required to avoid unjustified and imprudent reductions in 
overall capital levels and to reduce the potential for wide variations 
in capital requirements for similar types of exposures. While 
improvements in risk management practices and risk profiles may justify 
lower capital under Basel II, the FDIC believes that a correctly 
calibrated Basel II standard will produce overall minimum risk-based 
regulatory capital requirements that exceed the capital necessary to 
maintain a rating of ``adequately capitalized'' under current prompt 
corrective action (PCA) regulations that were mandated by the Federal 
Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).
    My testimony will focus on how Basel II can be adopted and 
eventually implemented in the United States given the concerns raised 
by QIS-4. I will focus on the importance of the relationship between 
the Basel II standards and the PCA regulations, specifically our 
existing U.S. leverage requirements. My testimony will argue that the 
QIS-4 results reinforce the need to revisit Basel II calibrations 
before risk-based capital floors expire and to maintain the current 
leverage ratio standards. Leverage requirements are needed for several 
reasons including:

 Risks such as interest-rate risk for loans held to maturity, 
    liquidity risk, and the potential for large accounting adjustments 
    are not addressed by Basel II.
 The Basel II models and its risk inputs have been, and will be 
    determined subjectively.
 No model can predict the 100-year flood for a bank's losses 
    with any confidence.
 Markets may allow large safety-net supported banks to operate 
    at the low levels of capital recommended by Basel II, but the 
    regulators have a special responsibility to protect that safety-
    net.

    Under the current formulation of Basel II, the leverage ratio 
standard will be more important than ever in guarding against losses to 
the insurance funds resulting from insufficient capital at the 
individual bank and the industry level.
Explaining the QIS-4 Results--Concerns Continue
    Following a preliminary analysis of the QIS-4 results completed in 
April, the agencies sshould determine the reasons for the significant 
declines in required capital levels and dispersion in reported results. 
Comprehensive analysis was needed to determine whether QIS-4 anomalies 
reflect actual bank differences in risk, limitations in the design and 
implementation of the QIS-4 study, variations in the stages of bank 
implementation efforts (particularly related to data availability), or 
whether the QIS-4 results indicate the need for adjustments to the 
Basel II framework.
    The agencies are not yet in a position to publish a comprehensive 
summary of our analysis of the QIS-4 results. The agencies have, 
nevertheless, determined that the QIS-4 results were driven to varying 
degrees by all of the aforementioned factors. As was envisioned in the 
design of Basel II, QIS-4 results show that the amount of required 
regulatory capital does vary with the risk characteristics of 
individual exposures. In many cases, however, variation in reported 
capital requirements had more to do with differences in banks' risk 
measurement methodologies, or the degree of their adherence to Basel II 
requirements as provided in the QIS-4 instructions, than with true 
differences in risk. In the design of QIS-4, the regulators did not 
intend to be prescriptive about how banks measure their own risk and 
recognized that the Basel II framework itself allows for considerable 
variation in capital requirements for identical exposures.
    In addition to the observed capital variation that reflected 
differences in banks' internal risk assessments, the FDIC's analysis 
suggests that much of the observed reduction in capital requirements 
under QIS-4 is built into Basel II's formulas. That is, the regulatory 
capital formulas in Basel II are inherently calibrated to produce large 
reductions in risk-based capital requirements.\1\ Better data, or 
better compliance by Basel II banks with the standards required by the 
framework, would not in this view mitigate the large reductions in 
capital requirements suggested by QIS-4. If anything, QIS-4 may 
understate the reductions in minimum capital requirements that would 
ultimately be expected under an up-and-running Basel II.
---------------------------------------------------------------------------
    \1\ See for example, Kupiec (2004), ``Capital Adequacy and Basel 
II,'' FDIC Center for Financial Research Working paper No. 2004-02, and 
Kupiec (2005), ``Unbiased Capital Allocation in an Asymptotic Single 
Risk Factor (ASRF) Model of Credit Risk,'' FDIC CFR Working Paper No. 
2005-04.
---------------------------------------------------------------------------
    Exhibits 1-3 in Appendix A provide a sense for the drop and 
dispersion of capital requirements suggested by QIS-4. At many 
institutions, the QIS-4 results show significant reductions in risk-
based capital. The Exhibit 1 table indicates the total minimum capital 
requirement of all participating banking organizations falls by an 
aggregate of 15 percent. Capital requirements declined by more than 26 
percent in more than half of the banking organizations in the study.
    Basel II sets capital requirements for selected portfolio groupings 
(for example, wholesale commercial and industrial, retail, real estate 
development, etc.). At the portfolio level, the Basel II capital 
requirements for most portfolio groupings decreased substantially 
across participating banking organizations. Most organizations reported 
double digit declines in capital requirements for most loan portfolios, 
with only a few portfolio categories posting increases (notably credit 
card exposures). For example, Exhibit 1 indicates that capital 
requirements for wholesale loans declined by 25 percent on average at 
the subject banking organizations. Capital requirements for so-called 
high volatility commercial real estate loans fell by 33 percent, while 
capital requirements for other commercial real estate loans fell 41 
percent. Capital requirements for small business loans fell by 27 
percent. Capital requirements for mortgage and home equity loans fell 
by 61 and 74 percent, respectively.
    In addition to problems resulting from the significant decline in 
the level of regulatory capital, concern persists over QIS-4 results 
showing an inconsistency in the capital results for similar risks 
across institutions. The Exhibit 2 and 3 charts show the wide variation 
in capital requirements around the averages reported in Exhibit 1. 
Further, in a sample of large corporate credits that had identical 
lending relationships with many of the QIS-4 institutions, individual 
banking organizations reported changes in minimum capital requirements 
that varied widely. Using the QIS-4 results of a single reporting 
institution to set a benchmark of comparison, QIS-4 participants 
reported minimum capital requirements for these identical credits that 
ranged from 30 percent less to 200 percent greater than the benchmark 
bank's calculation. For representative mortgage products, banking 
organizations reported risk weights that ranged from 5 percent to 80 
percent on identical exposures. These results suggest that QIS-4 
differences in minimum capital requirements are not entirely explained 
by true risk differences in bank products. Rather, a substantial source 
of the variation in Basel II capital requirements can be explained by 
differences in the risk inputs that individual organizations assign to 
identical exposures.
    Overall, the QIS-4 study confirms that the regulatory capital 
requirements set by the Basel II framework are very sensitive to 
individual banks' subjective assessments of risk. Achieving consistency 
in Basel II currently hinges on the hope that industry best practices 
and better data will lead to reduced dispersion in the capital 
treatment of similar loan portfolios across banks. At present, however, 
the QIS-4 results show that there is little commonality in the 
approaches the various banks are using to estimate their risk inputs. 
While this inconsistency may, in part, be corrected with refinements to 
internal systems and through improved regulatory guidance, differences 
are also inherent in the proposed framework and suggest the need for 
adjustments and safeguards going forward.

Notice of Proposed Rulemaking Will Set Forth Additional Prudential
Standards
    The U.S. agencies intend to publish a Notice of Proposed Rulemaking 
on the U.S. implementation of Basel II during the second quarter of 
2006 (Basel II NPR). The Basel II NPR will propose an advanced internal 
ratings-based approach that includes additional prudential safeguards 
designed to address the QIS-4 results. These safeguards include:

 A limit on the amount by which an institution's risk-based 
    capital may decline as a result of Basel II. These floors will be 
    retained for a minimum 3-year transition period and established at 
    95 percent the first year, 90 percent the second year, and 85 
    percent the third year.
 The release of floors only upon approval of an institution's 
    primary Federal regulator.
 Continuing evaluation of revisions to the framework given 
    actual experiences over the transition period.
 The retention of existing PCA standards, including the 
    existing leverage ratio standards.

    The FDIC continues to emphasize the importance of maintaining a 
minimum capital standard embodied in a leverage ratio. The Basel II 
standard is not intended to provide capital for all material risks. For 
example, the interest rate risk associated with most loans that banks 
hold to maturity, liquidity risk, and business risks such as the 
potential for large accounting adjustments, are not factored into the 
Basel II framework. Moreover, the framework relies on individual bank 
risk exposure estimates that are, by their nature, prone to inaccuracy. 
Further, these estimates are input into a regulatory model that is only 
a simplified expression of the actual risks retained by large complex 
banking institutions. These model risks, that are inevitable when banks 
are required to estimate their own risk inputs for a simplified 
regulatory capital model, may lead to inadequate regulatory capital 
requirements under the Basel II framework.
    Retaining the existing leverage ratio, a simple and effective 
standard, is an important pillar of the safety and soundness regime. 
The importance of the leverage ratio is highlighted by recent analysis 
conducted by the FDIC that draws upon the QIS-4 results. This analysis 
shows that under the current Basel II framework, the leverage ratio 
will serve a more important role than ever in ensuring that adequate 
levels of capital are maintained throughout the system.

Basel II and PCA: An Impending Conflict of Expectations
    The FDIC has analyzed how the Basel II standard would compare to 
U.S. capital standards currently applicable to insured institutions. We 
found that as a set of quantitative capital standards, Basel II appears 
to lower the bar considerably compared to current U.S. leverage and 
risk-based capital standards embodied in the agencies' PCA regulations.
    The QIS-4 exercise was conducted at the consolidated bank holding 
company level. QIS-4 does not quantify the minimum regulatory capital 
levels that may prevail under Basel II at the individual banks that 
participated in the study. Moreover, the capital requirements reported 
in Charts 1-3 in Appendix A are for total capital, which includes 
elements such as loan loss reserves, subordinated debt, and certain 
intangible assets that do not provide the same level of protection to 
the insurance funds as does core, or tier 1, capital. To better 
quantify the issues that are most directly relevant to the FDIC as 
insurer, we therefore estimated the tier 1 capital requirements that 
would apply at the 74 insured banks that are subsidiaries of the 26 
QIS-4 reporting organizations. Details on this estimation methodology 
are provided in Appendix B.
    Analysis of the QIS-4 data completed by the FDIC shows that Basel 
II produces minimum regulatory capital requirements that are 
unacceptably low under the existing PCA standards implemented pursuant 
to FDICIA. Using QIS-4 data, our analysis reveals that--should the 
leverage ratio be removed under Basel II--the majority of QIS-4 
institutions would be less than adequately capitalized (that is, under-
capitalized, significantly under-capitalized, or critically under-
capitalized) if they held only the level of capital generated by the 
Basel II formulas.
    As shown in the table on the next page, if the Basel II standards 
are the only constraint on the banks' minimum levels of capital, the 
majority of 26 banking companies participating in the QIS-4 study could 
fall to levels currently considered less than adequately capitalized 
under the PCA standards; that is, the minimum regulatory capital of 
these institutions would fall below the 4 percent leverage ratio.




    In other words, under the Basel II framework as currently 
fashioned, the leverage ratio will become the effective, binding 
minimum capital standard for most large U.S. banking companies. While 
we are aware that minimum regulatory capital requirements can constrain 
bank equity returns, we are not aware of any public policy studies or 
other claims that the current level of regulatory capital requirements 
is a barrier for the provision of additional banking services that are 
beneficial for the public. In the FDIC's view, Basel II should be 
calibrated in a manner that ensures that, for most banks in most 
circumstances, the overall minimum risk-based capital requirements 
(credit, operational, and market risk) exceed the minimum leverage 
capital requirements that are currently set in FDICIA and its 
implementing regulations.
    In terms of the capital impact of an up-and-running Basel II, if 
the present framework remains unchanged, the FDIC's analysis suggests 
that the future will bring even greater declines in capital 
requirements than are suggested by QIS-4. As described in Appendix B, 
the risk inputs of banks for QIS-4 purposes appear on average very 
conservative, more so than a strict reading of the framework would 
require. Moreover, the QIS-4 declines in required capital are achieved 
without fully factoring in capital reductions that can be achieved 
using credit risk hedges and third party guarantees under a fully 
implemented Basel II standard. These additional factors could generate 
significant reductions in capital requirements beyond those that were 
identified in the QIS-4 results. The FDIC does not believe that there 
is adequate support for the agencies to conclude that the capital 
reductions that likely will result from the current Basel II framework 
are commensurate with the reductions in the investment risk exposures 
of banks that will be engendered by improvements in risk management 
occurring under Basel II. Indeed, unless it can be demonstrated that 
Basel II will substantially reduce banks' credit risk exposure 
profiles, the increase in allowed leverage could easily lead to higher 
system-wide risks.
    Even if there were no leverage requirement and no PCA regulations, 
the FDIC would find the capital requirements coming out of QIS-4 to be 
too low for many reporting institutions. Banks operating with the 
benefit of a Federal safety net have operated at such capital levels 
for a time, but ultimately at a great cost to that 
safety net. In part because Basel II can be expected to generate such 
low capital requirements, the leverage ratio will play a more important 
role than ever in protecting the insurance funds.
    In the view of the FDIC, the leverage ratio is an effective, 
straightforward, tangible measure of solvency that is a useful 
complement to the risk-sensitive, subjective approach of Basel II. The 
FDIC is pleased that the agencies are in agreement that retention of 
the leverage ratio as a prudential safeguard is a critical component of 
a safe and sound regulatory capital framework. The FDIC supports moving 
forward with Basel II, but only if U.S. capital regulation retains a 
leverage-based component.

Expectations for Insured Banks under Basel II
    The Federal safety net in the United States extends explicitly to 
insured banks, not their holding companies. The absolute accountability 
of insured institutions for their own governance, and for maintaining 
an adequate level of capital, is of fundamental importance in 
controlling the potential cost of that safety net. That is why a 
critical element for the success of Basel II as a safety-and-soundness 
initiative is maintaining appropriate expectations for insured banks.
    In concrete terms, insured banks that adopt Basel II will need to 
calculate and report a capital requirement that is appropriate for 
their own risk exposures. Capital reductions derived from 
diversification of exposures held in separate legal 
entities may prove to be only hypothetical should one of the entities 
become undercapitalized on a stand-alone basis. This does not mean that 
holding companies will need to maintain separate and duplicative Basel 
II infrastructures at every insured subsidiary. Indeed, to the extent 
that regulators expect the accurate measurement of risk at the holding 
company level, that would seem to require compatible systems at all 
subsidiary legal entities. In terms of managing and controlling the 
government's deposit insurance exposure, however, effective risk 
control requires that capital calculations be geared to the unique 
risks and exposures of each insured subsidiary.

Transparent Information--Ongoing Analysis Required
    The FDIC is committed to transparency, and it is our belief and 
expectation that the banks and their primary Federal regulators will 
collaborate and share information in a manner that allows each agency 
to address its concerns with regard to the new capital framework. As 
outlined above, the QIS-4 study indicates that modifications of the 
current Basel II framework are likely to be necessary to ensure that 
regulatory standards require adequate bank capital and equal capital is 
required for equal risk. In order to reach a prudent judgment regarding 
the safety and soundness implications of any such proposed changes and 
to ensure a level playing field within the United States, the FDIC and 
the other banking regulatory agencies must obtain adequate information 
regarding all participating banks' internal credit risk modeling 
systems and resulting minimum capital requirements. From the FDIC's 
perspective of assessing risks to the insurance funds, collaboration 
must include access to information about the critical assumptions, 
models and data used to implement capital requirements based on banks' 
own estimates of risk.

Competitive Equity--Basel I-A Advance Notice of Proposed Rulemaking
    Throughout the Basel II process, the FDIC has expressed concerns 
about the potential detrimental effects that the new framework could 
have on competition within the U.S. banking sector. Indeed, the QIS-4 
results suggest that the competitive ramifications could be profound. 
Absent modifications to the current and proposed risk-based capital 
frameworks, the FDIC believes that the non-Basel II banking sector 
could be placed at a competitive disadvantage to larger banks subject 
to the Basel II framework. To address these concerns, the agencies have 
issued an Advanced Notice of Proposed Rulemaking to begin the process 
of developing an alternative for non-Basel II adopters (Basel I-A 
ANPR).
    The Basel II banks already enjoy a pricing advantage over their 
smaller competitors due to their asset size, underwriting volume, and 
related economies of scale. However, this pricing advantage could be 
magnified by the reduced risk-based capital requirements of Basel II. 
The higher capitalized non-Basel II banks may become more attractive 
acquisition targets for Basel II adopters. Further, the results of the 
QIS-4 exercise show that the advantage of the Basel II framework could 
be the greatest in those areas where credit risks historically have 
been the lowest.
    Under the Basel II framework, capital requirements for residential 
mortgages, home equity loans, and similar exposures drop significantly. 
For example, risk-based capital requirements for single-family 
residential mortgage exposures fall from 4 percent under current Basel 
I standards to 1.5 percent under Basel II (based on the average risk-
weight reported in QIS-4). Moreover, Basel II, as seen in the QIS-4 
results, greatly expands the disparity in minimum required risk-based 
capital between lower risk and higher risk credits. For example, prime 
mortgages will receive a much lower capital charge than subprime 
mortgages under Basel II. In contrast, prime mortgages and subprime 
mortgages are generally assigned to the same risk weight category under 
existing risk-based capital rules. It is reasonable to assume that 
there will be a similar disparity between capital requirements for 
prime and subprime credit card exposures. As a result, without 
mitigating changes to the competing frameworks, non-Basel II banks 
could be placed at a severe competitive disadvantage to Basel II banks 
in prime-grade markets while possibly gaining a competitive advantage 
over Basel II banks in subprime markets. The end result of such 
disparate capital treatments could be a migration of high risk credits 
away from Basel II banks and toward non-Basel II banks. We must monitor 
this potential change very carefully from a safety and soundness 
perspective as well as monitor changes in the exposure of the insurance 
funds.
    In order to advance a full dialogue of the competitive concerns 
associated with changes to the capital framework, the agencies issued 
the Basel I-A ANPR that outlines potential changes to risk-based 
capital regulations for all U.S. banks. The agencies are soliciting 
comments on how to achieve greater risk sensitivity for capital in a 
way that does not create undue burden for insured institutions and is 
consistent with safety and soundness objectives.
    The FDIC is aware that competitive equity concerns are not the same 
for all banks. Some community banks choose to maintain large amounts of 
risk-based capital--not because they operate in a risky manner, but 
rather because they have lower risk appetites or tolerances. Therefore, 
we are requesting comments in the Basel I-A ANPR concerning the 
possibility of allowing these types of institutions to opt out of 
proposed changes.
    In addition to addressing potential competitive inequities and 
recognizing industry advances in credit risk measurement and mitigation 
techniques, the Basel I-A ANPR will also propose ways to modernize the 
risk-based capital rules for all U.S. banks. Key components of the ANPR 
ask for comment on:

 Increasing the number of risk-weight categories for bank 
    credit exposures.
 Expanding the use of external credit ratings as an indicator 
    of credit risk for externally rated exposures.
 Expanding the capital reductions available from the use of 
    collateral and guarantors.
 Adopting loan-to-value ratios and credit score measures to 
    assign risk weights to residential mortgages.

    We believe that most, if not all, of these proposals can be applied 
using information that is readily available to banks. However, we have 
asked for comment on whether the trade-off of a more risk-sensitive 
capital framework is justified by any possible burden generated by its 
implementation.
    Finally, we are asking for comment on any concerns not addressed by 
the agencies in the ANPR. The FDIC is confident that by listening to 
the needs and concerns of the banking community and other commenters, a 
revised capital framework can be put in place for non-Basel II banks 
that will mitigate many of the competitive equity concerns.

Conclusion
    Going forward, the FDIC plans to issue the Basel II NPR, and 
coordinate its issuance with a Basel I-A Notice of Proposed Rulemaking 
(this will follow the ANPR) in a manner that will allow for some 
overlap in the comment period for the two notices of proposed 
rulemakings. This process will allow the two proposals to be compared 
side-by-side so that the public can fairly determine the possible 
competitive implications of the overall package of proposed changes to 
U.S. capital regulation.
    We are working diligently to ensure that, as originally envisioned, 
the new regulatory capital framework articulated by Basel I-A and Basel 
II enhances the safety and soundness of the U.S. banking system. The 
U.S. agencies must continue to work closely together, share 
information, reach conclusions on important changes to the proposed 
framework, and reassess the impact of any such changes. The FDIC is 
working with the other agencies to develop a framework that achieves 
this broad objective and preserves a set of straightforward minimum 
capital requirements to complement the more risk-sensitive, but also 
more subjective, approaches of Basel II. We also want to maintain 
competitive equity and achieve results under Basel II that are less 
extreme and more consistently applicable across banks.
    The FDIC, like the other banking agencies, will proceed with the 
implementation of Basel II in an appropriately deliberative manner and 
with full consideration of the comments of all interested persons.



                  PREPARES STATEMENT OF JOHN M. REICH
                 Director, Office of Thrift Supervision
                           November 10, 2005

Introduction
    Good morning, Chairman Shelby, Ranking Member Sarbanes, and Members 
of the Committee. Thank you for the opportunity to discuss the views of 
the Office of Thrift Supervision on the development of the Basel II 
capital framework in the United States for our largest U.S. financial 
institutions and the parallel modernization of Basel I for our other 
institutions.
    The development of Basel II has been underway, internationally, for 
a number of years. In the United States, the four Federal Banking 
Agencies (FBA's) commenced the formal rulemaking process with the 
issuance of an Advanced Notice of Proposed Rulemaking (ANPR) in 2003. 
The parallel modernization of domestic risk-based capital requirements 
stemming from Basel I (our current risk-based capital standards), aimed 
at institutions that will not adopt Basel II, has been discussed among 
the regulators for some time. It formally began, however, only a few 
weeks ago with the issuance of an ANPR.
    The goal of Basel II is to produce a risk-based capital system that 
promotes effective risk management, maintains capital adequacy, and 
increases the transparency of risks undertaken by our largest, 
internationally active institutions. The goals of the FBAs are to 
ensure that Basel II, as implemented in the United States, and the 
parallel modernization of our current risk-based capital standards, 
will enhance the risk management, capital adequacy, and risk 
transparency of all our financial institutions, while maintaining the 
safest and soundest banking system in the world. OTS will endorse the 
implementation of systemic changes to our capital rules only if they 
advance these goals.
    Although we are more than 2 years from the start of a proposed 4-
year phase-in of Basel II, there are significant hurdles to overcome 
before we can represent to you, Mr. Chairman, that it is ready to be 
implemented. This is underscored by a recent quantitative impact study, 
QIS-4, conducted by the FBA's. QIS-4 indicated that further, 
significant revisions are needed before we can implement Basel II in 
the United States. We also need to resolve difficult policy issues in 
the modernization of our current risk-based capital standards. We 
remain committed to meeting the challenges raised in the development 
and implementation of both capital systems.
    Today, I will address some of these issues and provide an update on 
the approach to risk-based capital contemplated by Basel II, as well as 
issues that our U.S. institutions are expected to face under a revised 
Basel I-based framework.
    Given that the banking and thrift industries are profitable and 
well-capitalized, with few troubles in recent years, you may reasonably 
ask what is broken and why do we need to fix it? The answers start with 
the growing exposure of large and internationally active institutions 
to steadily increasing risks that are not captured very well--if at 
all--under our current risk-based capital framework.
    Much of the public debate about Basel II has been about changes in 
minimum regulatory capital; however, the new framework goes beyond 
that. It focuses first and foremost on enterprise-level risk 
management, and encourages ongoing improvements in risk assessment 
capabilities. Basel II also provides for governance changes, induding 
board of director accountability for risk management. Basel II may 
allow for reduced minimum risk-based capital requirements for certain 
institutions, where a reduction is justified and commensurate with real 
and verifiable risk exposure. That would only be available, however, 
where an institution can demonstrate--to the satisfaction of its 
primary regulator--that its risk management capabilities and resultant 
risk reduction merit such a change in capital requirements.
    There is also a need to modernize Basel I risk-based capital 
requirements in order to minimize competitive effects of adopting Basel 
II and to better align capital requirements with the wide range of risk 
profiles of domestic financial institutions.

Overview and Background of the Basel Process
Basel I
    Basel I, issued 1988 by the Basel Committee on Banking Supervision 
(BCBS), provided a set of capital principles designed to strengthen 
capital levels at large, internationally active banking organizations, 
and to foster international consistency and coordination.\1\ Although 
Basel I applied only to the largest, internationally active banks in G-
10 countries (countries outside the G-10 were encouraged to adopt it 
for their banks operating internationally), the themes of Basel I were 
intended to apply to all banking organizations worldwide, of any size 
and activity.
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    \1\ The BCBS identified two fundamental objectives at the heart of 
its work on regulatory convergence under Basel I. As the BCBS stated, 
first, ``the new framework should serve to strengthen the soundness and 
stability of the international banking system; and [second,] the 
framework should be fair and have a high degree of consistency in its 
application to banks in different countries with a view to diminishing 
an existing source of competitive inequality among international 
banks.''
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    While OTS did not participate in developing Basel I, we applied it 
to the institutions we regulate, along with the other FBA's. Throughout 
implementation of Basel I, the FBA's developed risk-based capital 
standards consistent with its underlying principles, but with 
modifications intended to enhance risk sensitivity and conform to the 
unique needs of the U.S. banking system.
    When Basel I was issued, the BCBS recognized that it was only a 
start, and that more refinement would take place over time. In today's 
sophisticated financial marketplace, Basel I is a relatively simplistic 
framework. For example, it makes no distinction between a well-
underwritten commercial credit to a strong borrower and a relatively 
weak commercial credit to another borrower. Both are assigned the same 
(100 percent) risk weight. Similarly, residential mortgages, which can 
vary widely in quality, are assigned either a 100 percent risk weight 
or, if prudently underwritten, a 50 percent risk weight (most 1-4 
family residential mortgages). Currently, even the lowest credit risk 
residential mortgages are subject to a 50 percent risk weight; whereas 
the highest credit risk residential mortgages are subject to no more 
than a 100 percent risk weight.
    As stated by the BCBS, advances in risk management practices, 
technology, and banking markets have made the 1988 Accord's simple 
approach to measuring capital less meaningful for many institutions. 
Likewise, improvements in internal processes, more advanced risk 
measurement techniques, and more sophisticated risk management 
practices have dramatically improved the monitoring and management of 
risk exposures and activities. In short, the static rules of the 1988 
Accord have not kept pace, and in fact, were not designed to keep pace 
with advances in risk management.

Basel II
    As financial instruments, systems, and products became more 
complex, the BCBS began designing a new regulatory capital framework. 
This framework, Basel II, incorporates advances in risk measurement and 
management practices, and attempts to assess capital charges more 
precisely in relation to risk, and in particular, credit risk and 
operational risk. The international agreement articulating these 
principles was issued in June 2004.
    Basel II calls for institutions to measure and maintain internal 
data about different loan types for credit and operational risk. These 
requirements help to promote improved risk management systems. The 
FBA's also expect institutions to continue to develop and improve their 
internal economic capital models to more accurately measure their own 
unique enterprise risk. While Basel I focused on measuring risk 
exposure on an asset-by-asset basis, placing assets into simple, 
broadly defined risk buckets, Basel II focuses on enterprise-wide risk 
management, and encourages institutions continually to evaluate and 
assess their risk exposure.
    There are numerous reasons for our U.S. banking system to move 
forward to a more sophisticated, risk-based framework for evaluating 
capital adequacy in institutions implementing Basel II. At the same 
time, it is important to identify ways to improve our Basel I-based 
system for the thousands of institutions that will not adopt Basel II. 
We believe that these objectives are not mutually exclusive, but rather 
mutually dependent in order to prevent potential competitive inequities 
between Basel II adopters and non-adopters.

Implementation of Basel II in the United States
    While OTS supports the concepts, principles, and stated goals of 
Basel II, implementation in the United States will occur only when the 
FBA's are confident that it can be achieved in a manner that 
affirmatively strengthens and does not undermine our financial system. 
This requires us to maintain the safety and soundness of Basel II 
adopters and implement a modernized Basel I-based system that treats 
all U.S. institutions fairly and consistently regardless of the risk-
based capital regime that they follow.
    The FBA's recently revised the proposed Basel II timeframes to 
allow more time consistent with these principles. In addition to 
delaying the start to 2008 and adding an additional phase-in year, the 
FBA's provided for greater supervisory control over individual 
institutions at each step of Basel II implementation,\2\ along with 
progressively less binding capital floors until fully implemented in 
2012.\3\
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    \2\ The new timeframes provide for a nonbinding ``parallel run'' of 
the Basel II framework starting in 2008; however, institutions may 
enter the parallel run only with the permission of their primary 
regulator. This will require an institution to demonstrate to its 
regulator that it has accurate and reliable systems in place for 
enterprise-wide risk management. During the parallel run phase, 
institutions seeking to implement the Basel II framework would also be 
required to comply with existing Basel I requirements. Throughout 
implementation, institutions would be subject to close supervisory 
scrutiny and a strict leverage ratio requirement.
    \3\ The phase-in schedule provides that, in the first year (as 
early as 2009), an institution's capital reduction is subject to a 
floor of 95 percent of the level calculated for risk-weighted assets 
under Basel I. Reductions in risk-weighted assets would be limited to a 
90 percent floor in the second year of implementation (as early as 
2010), and an 85 percent floor in the third year (as early as 2011). 
Supervisory approval is required in each successive year to go to the 
next floor. During implementation, an institution's primary regulator 
will closely monitor its systems for gathering and maintaining data, 
calculating the Basel II capital requirement, and ensuring the overall 
integrity, and safety and soundness, of the application of the Basel II 
framework.
---------------------------------------------------------------------------
    While the FBA's have agreed to proceed with these safeguards in 
place, the Basel II implementation process remains dynamic. The FBA's 
are currently working on a Notice of Proposed Rulemaking (NPR) as a 
precursor to issuance of a rule implementing the Basel II framework in 
the United States.
    In conjunction with issuance of an NPR, the FBA's plan to issue 
comprehensive proposed guidance consolidating previously issued 
guidance on retail, corporate, and operational risk and including 
issues not previously addressed, such as securitization, credit risk 
mitigation, equity exposures, and various wholesale transactions. 
Industry reaction and comment on the consolidated guidance will be very 
important since it will be the first iteration of U.S. regulatory 
policy on some of these subjects. In addition, this will be the first 
opportunity for the industry to assess the adequacy of the guidance 
based on the standards enumerated in the NPR. The FBA's plan to make 
additional adjustments to the guidance after receiving industry 
comments and to ensure consistency with a final rule.
    The FBA's are currently working toward issuance of a final rule in 
mid-2007, which is a critical timing issue for U.S. financial 
institutions to have sufficient lead-time to prepare for a 2008 
parallel run. We recognize that the 2007 final rule may not even be the 
last word on Basel II. Rather, we anticipate that further rulemakings 
may be necessary to refine the Basel II framework for use in the United 
States based on our experiences during the parallel run and subsequent 
implementation stages.\4\
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    \4\ It is also important to note that OTS, like the OCC, is subject 
to Executive Order 12866, which requires executive agencies to 
determine whether a proposed rule is a ``significant regulatory 
action.'' OTS has determined that the Basel II NPR will be a 
significant regulatory action based on the potential effects of the 
rule. Thus, OTS is required to prepare a regulatory impact analysis of 
the NPR, including an analysis of the need for regulatory action, the 
costs and benefits of the NPR and alternative approaches, and the 
potential impact on competition among financial services providers. 
Pursuant to the Executive Order, the NPR and accompanying regulatory 
impact analysis will be submitted to the Office of Management and 
Budget for review prior to publication of the NPR.
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Modernization of Our Current Risk-Based Capital Standards
    On October 19, 2005, the FBA's issued an ANPR announcing the start 
of the rewrite of Basel I-based domestic capital standards. OTS was an 
early advocate of revising and modernizing the existingstandards. We 
strongly support amending our current risk-based capital standards 
simultaneously, or in close proximity to, Basel II. Our view is that 
these revisions should encompass meaningful reforms, while avoiding 
imposing costly analytical processes on smaller banks and thrifts. 
Modifying the existing rules with more accurate riskweights allocated 
to a wider range of asset buckets will significantly improve the 
current framework. Applying commonly used risk criteria for identifying 
different levels of risk will further enhance the existing framework. 
This would provide a more granular, risk-sensitive system of 
determining appropriate levels of capital, by asset type, and within 
asset type.
    Modernization of Basel I -based capital standards will also 
mitigate potential competitive inequities that may arise with the 
implementation of Basel II.
    In considering revisions to our current capital rules, five general 
principles have guided the FBAs. These are:

 Promoting safe and sound banking practices and maintaining a 
    prudent level of regulatory capital;
 Maintaining a healthy balance between risk sensitivity and 
    operational feasibility;
 Avoiding undue regulatory burden;
 Creating appropriate incentives for banking organizations; and
 Mitigating material distortions in the amount of regulatory 
    risk-based capital requirements for large and small institutions.

    The recently issued ANPR for modernizing our domestic risk-based 
capital standards focuses on a number of potential modifications. These 
include increasing the number of risk weight categories for credit 
exposures; using loan-to-value (LTV) ratios, credit assessments, and 
other broad measures for assigning risk-weights to residential 
mortgages--a particularly important issue for OTS; modifying the risk-
based capital requirements for certain commercial real estate 
exposures; and increasing the risk sensitivity of capital requirements 
for other types of retail, multifamily, small business, and commercial 
exposures.
    Two additional issues particularly important to OTS are expanding 
the number of risk weight categories to which credit exposures may be 
assigned; \5\ and continuing to consider private mortgage insurance 
(PMI) in the risk-weighting of residential mortgages.
---------------------------------------------------------------------------
    \5\ Current categories are 0, 20, 50, 100, and 200 percent, and 
possible new and additional categories for consideration are 10, 35, 
75, 150, and 350 percent.
---------------------------------------------------------------------------
    As we consider modernizing our current risk-based capital 
requirements to increase its risk sensitivity and minimize potential 
competitive inequities, we realize that some banking organizations may 
prefer to operate under the existing Basel I framework, unchanged, to 
determine their minimum risk-based capital requirements. The ANPR 
anticipates this option and expressly invites comment. We expect 
additional comment about flexibility, and balancing safety and 
soundness with regulatory burden concerns.

The QIS-4 Survey
    There have been a series of structured and coordinated information 
gathering exercises conducted internationally, referred to as 
Quantitative Impact Studies (QIS). The most recent data collection, 
QIS-4, was an important milestone in U.S. development of the Basel II 
framework. The FBA's initiated QIS-4 to gauge the potential impact of 
Basel II in the United States. Before discussing the results of QIS-4, 
it is important to note its inherent limitations.
    In October 2004, the FBA's released the QIS-4 materials, and 26 
institutions responded to the study. The initial results of QIS-4 
revealed a material drop in required risk-based capital compared to 
Basel I requirements, and significant dispersion among the respondents 
with regard to the Basel II minimum risk-based capital requirement. As 
a result, this past April the FBA's delayed the planned 2005 issuance 
of the Basel II NPR in order to provide time to conduct additional 
analysis on the QIS-4 data.
    Several important factors likely influenced the overall quality of 
the QIS-4 data. These include unsettled and/or incomplete guidance on 
Basel II from the FBA's, as well as the fact that many institutions are 
still developing the data and systems required to fully implement Basel 
II. The QIS-4 process was instructive, however, on the state of 
readiness of--and need for additional preparation by--both the 
regulators and the industry.
    Notwithstanding these factors, several aspects of the data bear 
further scrutiny. Chief among these was a material difference in 
required risk-based capital levels among respondents that was not fully 
explained by differences in their enterprise risk profiles. We are 
particularly concerned with analyses indicating materially disparate 
capital charges for credit exposures that generally pose comparable 
levels of credit risk.
    Another unsettling aspect of QIS-4 was a material drop in overall 
risk-based capital. In fact, every category of credit risk showed 
declines in capital requirements except for credit cards. This is 
clearly an issue that requires further study to ensure that the Basel 
II capital standards are adequate.
    With respect to mortgage lending, the QIS-4 results demonstrated 
large capital reductions for mortgage and home equity lending. While 
this is an especially important result because of commercial banks' 
existing concentration in mortgage-related assets,\6\ some of the 
decline in capital for prime mortgage lending was expected because QIS-
4 did not address interest rate risk--typically, one of the most 
significant risks for prime mortgage lending. In fact, the drop in 
capital for prime mortgages highlights the importance of realigning 
risk-based capital requirements to more closely correspond to actual 
credit risks, while also taking into account interest rate risk-a 
critical element in evaluating appropriate capital levels.\7\
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    \6\ Since 1995, commercial banks have increased their holdings of 
residential-related mortgages 174 percent in real dollars, from $991 
billion to $2.72 trillion. As a percentage of assets, commercial bank 
holdings of residential-related assets have increased 40 percent, from 
23.0 percent of assets in 1995 to 32.3 percent of assets today. By 
contrast, thrifts have increased their holdings of residential-related 
mortgages in real dollars by 62 percent, but as a percentage of assets 
thrift holdings are actually 4 percent lower than in 1995, from 75.6 
percent of assets in 1995 down to 72.5 percent of assets today.
    \7\ By their very nature, conservatively managed mortgage lenders 
typically have substantially lower credit risk exposure than lenders 
concentrating in other retail lending activities. A major risk for 
mortgage lenders, interest rate risk, is also greatly reduced by the 
presence of sound and prudent interest rate risk management practices, 
including access to the secondary mortgage market.
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    In recognition of the substantial interest rate risk associated 
with many forms of mortgage lending, OTS has developed a rigorous 
interest rate risk model. It is our experience, working with our 
interest rate risk model for well over a decade, that savings 
associations have modified their interest rate risk-taking behavior 
based on information and tools provided by our model. How interest rate 
risk is ultimately treated under Basel II is an important issue for OTS 
and the thrift industry, as well as for banks that focus on mortgage 
lending activities.
    A disturbing result from QIS-4 was the sizable reduction in 
required capital for horne equity lines of credit. Since the end of 
2000, home equity lines of credit on institution balance sheets have 
grown by an extraordinary 354 percent, to $534 billion. This is due, in 
large part, to the low interest rate environment of the last several 
years for mortgages and mortgage-related products. We are concerned 
that the study results may reflect only our recent experience, and not 
accurately portray risks present in a full economic cycle. This remains 
an area deserving of additional attention as we move forward with our 
rulemaking and the development of guidance on Basel II.
    The results of QIS-4 suggest that Basel II remains a work in 
progress in the United States, both for the PBA's and institutions that 
intend to implement it. The PBA's are committed to creating a 
regulatory framework that resolves the concerns raised by QIS-4. There 
is a significant amount of work remaining to create a regulatory 
structure that ensures risk sensitive results, promotes fair 
competition, and ensures the continued safety and soundness of the U.S. 
financial system.

Public Policy Concerns with Basel II and the Modernization of Current
Risk-Based Capital Standards

Timing
    Implementing a more risk sensitive capital framework in the United 
States is an important objective, but we must be vigilant not to harm 
our existing banking system. Longstanding capital adequacy standards 
combined with a well-established and highly respected supervisory 
structure have delivered a banking system that is healthy and robust. 
OTS supports Basel II, provided its implementation enhances our 
existing banking system. It is important that we review this objective 
at each step of the way toward Basel II implementation.
    As we take the steps necessary to move to a more advanced and risk 
sensitive capital framework, it is important to exercise caution and 
allow for sufficient time to consider how best to proceed in 
implementing Basel II in the United States. The safeguards we recently 
added, including a parallel run year, followed by 3 years of capital 
floors, and ongoing regulatory and supervisory review, will help us 
proceed prudently toward Basel II implementation.

Competitive Considerations
    Implementing more risk-sensitive capital requirements (without 
undue burden) is as important for small community banking organizations 
as it is 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 capital 
standards are important, we must avoid potential negative effects on 
U.S.-based institutions not operating internationally.
    It is important to maintain comparable, although not necessarily 
identical, risk-based capital standards for all U.S. institutions with 
respect to lending activities that have the same risk characteristics. 
Although our largest institutions should receive capital treatment 
commensurate with their ability to reduce risk via diversification and 
technology, community banking organizations should not be competitively 
disadvantaged in the process. Competitiveness issues raised by Basel II 
necessitate an across-the-board examination of capital standards for 
all our institutions. This provides an opportunity to reexamine our 
current risk-based capital standards, and to take any appropriate steps 
to reduce potential competitive inequities for community banking 
organizations.
    OTS is pleased that the modernization of Basel I-based capital 
standards, an initiative we championed, has evolved into a commitment 
by all the FBA's. The goal of this initiative is to achieve greater 
risk-sensitivity without undue complexity. We believe this can be 
accomplished by, among other things, increasing the available asset 
``risk-buckets'' first enunciated under Basel I, and by applying 
commonly understood criteria for assessing the relative risk within and 
among various loan types.
    As previously described, while Basel II includes minimum risk-based 
capital requirements for credit and operational risk, it does not 
include specific capital requirements for interest rate risk. OTS 
believes that this significant risk, especially important in mortgage 
products, should be addressed by the FBA's consistently. If the Basel 
II construct for interest rate risk is maintained, it will be important 
to prepare comprehensive interagency guidance on how we expect this 
risk to be measured and managed by U.S. institutions implementing Basel 
II.

Leverage Requirements, Prompt Corrective Action, and other Safeguards
    An issue garnering significant attention under Basel II is the 
interrelationship--and tension--between a risk-insensitive leverage 
ratio and risk-based capital requirements. On the one hand, the 
increased risk sensitivity offered by Basel II is intended to align 
risk-based capital requirements more closely with a banking 
organization's own internal capital allocation. A leverage requirement 
is fundamentally different, however, in that it constrains the extent 
to which an institution can leverage its equity capital base. In 
effect, a risk-insensitive leverage requirement--a backstop protecting 
the Federal deposit insurance funds--potentially operates as a 
disincentive for an institution to invest in the least risky assets, 
while not constraining its investment in high-risk assets.
    Prompt corrective action (PCA), which includes the leverage ratio 
constraint, was instituted in the late 1980's in response to the need 
for more aggressive and timely supervisory intervention in the face of 
stressed and declining capital levels. PCA provides a graduated capital 
structure for identifying categories of capital adequacy based on both 
leverage ratio and risk-based capital.\8\
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    \8\ The FBA's currently define a ``well-capitalized'' institution 
as having Tier 1 capital of 5 percent, ``adequately capitalized'' is 
set at 4 percent, ``under-capitalized'' at less than 4 percent, 
``significantly undercapitalized'' at less than 3 percent, and 
``critically under capitalized'' at less than 2 percent Tier 1 capital.
---------------------------------------------------------------------------
    PCA and its leverage ratio are based on institution-wide levels, 
rather than individual asset risks as prescribed by Basel II. 
Notwithstanding Basel II's focus on risk sensitivity, an institution 
with a concentration of low risk assets will be constrained by the 
leverage ratio; as a result, its capital will not be risk sensitive. 
Conversely, the leverage ratio may impose no restraint on a relatively 
high-risk institution, yet that institution would be constrained, 
presumably, by an effective risk-sensitive standard. Thus, a risk-
insensitive leverage ratio works against a financial institution's 
investment in low-risk assets.
    Today's expanding universe of off-balance-sheet activity also goes 
untouched by existing leverage requirements. Thus, a regulatory capital 
system with a leverage ratio not sensitive to risk operates as the 
principal binding capital constraint on financial institutions, rather 
than a backstop measure. Such a system may perversely motivate low 
credit risk lenders to pursue riskier lending.
    Along with other prudential safeguards, leverage is an important 
capital buffer. OTS remains firmly and unequivocally committed to 
maintaining an appropriate leverage ratio that is sufficiently rigorous 
and also flexible enough to address the unique operating 
characteristics of all types of lenders.

Conclusion
    OTS supports the goals and objectives of Basel II, and we are 
committed to implementing a more risk-sensitive capital framework for 
all our regulated institutions. While it is important that the United 
States continue to move forward on Basel II, we should proceed in a 
cautious, well-studied, and deliberate manner. The revised timeframe 
for Basel II is consistent with this goal; however, it is critical that 
all interested parties--including the industry, Congress and the 
regulators--continue an active, open, and thorough dialogue regarding 
Basel II. We will continue to work together with the Members of this 
Committee, the other FBA's, and with our international colleagues on 
these issues.
    We stand ready to make any necessary adjustments to ensure that 
domestic implementation of Basel II, in conjunction with the 
modernization of Basel I-based capital standards, appropriately enhance 
capital adequacy and risk management in the United States. Most 
importantly, we will continue to seek assurance, Mr. Chairman, that 
these efforts not yield unintended consequences to our U.S. 
institutions.
    Thank you, Mr. Chairman and Ranking Member Sarbanes, for holding 
this important hearing, and for the continued interest and hard work of 
you and your colleagues and staffs on these important issues. We will 
be happy to provide any additional information that you may require 
regarding the ongoing Basel II and Basel I rewrite processes.

                               ----------
                PREPARED STATEMENT OF L. WILLIAM SEIDMAN
         Former Chairman, Federal Deposit Insurance Corporation
             Former Chairman, Resolution Trust Corporation
                           November 10, 2005

    Mr. Chairman and Members, thank you for inviting me to this 
important hearing. I have not been before this distinguished Committee 
for a long time, so please excuse me if I am a little rusty.
    Basel II has been billed as an important safety and soundness 
initiative that is needed to correct the deficiencies of Basel I. Basel 
II will force banks to hold capital, it is said, for the hidden and 
undercapitalized risks Basel I allowed them to take.
    I was a part of the delegation at Basel I, which had as its 
principal objective creating common capital minimums for banks around 
the world. It has achieved that objective. Now Basel II wishes to 
improve that minimum standard through use of economic models to 
evaluate risk.
    This is a good sentiment--however, unfortunately, as the agencies 
announced in April 2005, the results of a quantitative impact study 
(QIS-4) of proposed Basel II showed material reductions in minimum 
required capital for the population of U.S. institutions that submitted 
their capital estimates for the study. The study showed a 15.5 percent 
decline in the average bank's minimum required capital and more than 
half of the participating banks posted declines in excess of 26 
percent. Subsequent studies produced by the Federal Deposit Insurance 
Corporation suggest that minimum risk-based capital standards at many 
Basel II eligible banks could fall far below the leverage standards set 
by prompt corrective action (PCA) for well-capitalized banks. The 
original intent of Basel II was to more closely align minimum 
regulatory capital with actual risk, not to materially reduce overall 
capital levels within the banking system.
    The QIS-4 study also showed a significant amount of dispersion in 
minimum capital requirements across institutions and across different 
portfolio types. Some dispersion in capital results may be expected 
because the Basel II framework allows for a significant degree of 
subjectivity in developing inputs to the capital risk formulas. 
However, the substantial variance shown in QIS-4 results for categories 
that should be fairly similar among different institutions--retail 
lending for example--raise questions as to the prudence of adopting a 
capital regime that results in such a wide range of perceptions of risk 
across banking institutions.
    It is far from certain that the risk measurement systems in banks 
have become so precise that they can operate safely at reduced capital 
margins mandated by Basel II and calculated by banks in the QIS-4 
study. Compared to Basel I, the Basel II capital standard may better 
align capital with the risks taken by banks, but the new standard is 
far from foolproof. The Basel II standard omits some significant risks 
faced by banks. Interest rate risk was a key part of the early stages 
of banking and the thrift crises of the 1980's, yet the Basel II 
standards do not cover interest rate risk. The Basel II capital 
standard is also based on estimates from the banks' own data. Make no 
mistake, these are estimates and are subject to errors. Moreover, Basel 
II uses these imperfect estimates in a capital formula that, while 
complicated and derived from financial theory, is almost certainly an 
oversimplification of the actual risks taken by banks. So can we be 
reasonably sure that the Basel II standards would provide sufficient 
capital for banks? Not in my judgment.
    We learned a number of lessons during the bank and thrift crisis 
years of the late 1980's and early 1990's. One of these lessons is that 
even sophisticated models can prove to be wrong when faced with 
unanticipated volatility and changing conditions that invalidate bank 
model assumptions. Models calibrated to fit performance in good times 
often will perform badly when market conditions deteriorate. Model 
risk, an unavoidable by-product of sophisticated risk measurement 
practices, underscores the importance of retaining capital safeguards, 
such as the leverage ratio and prompt corrective action minimum equity 
capital standards.
    While the details of the agencies' QIS-4 analysis have not yet been 
made public, there are some publicly disclosed Basel II minimum capital 
level results that can be compared to existing regulatory benchmarks, 
and these comparisons should raise concerns. My specific concerns focus 
on minimum capital requirements for residential mortgages. You are 
aware no doubt that some prominent officials in the banking regulatory 
community have been vocal about the need to raise minimum regulatory 
capital requirements for the housing GSE's, Fannie Mae and Freddie Mac, 
which currently are about 2.5 percent for mortgages held on the GSE 
balance sheets. There seems to be a growing consensus in these halls 
that the safety and soundness of the financial system may be enhanced 
by increasing the minimum capital position that GSE's are required to 
maintain. At the same time that bank regulators have weighed in on GSE 
regulation, a recent study by the Federal Reserve Board \1\ stated that 
the Basel II minimum capital requirement for GSE conforming mortgages 
held in banks would be below 50 basis points. I fail to understand how 
a bank regulator may reconcile these two positions. Common sense 
dictates that if 2.5 percent is too low for mortgages held in the 
GSE's, then it must also be too low for mortgages held in banks.
---------------------------------------------------------------------------
    \1\ ``An Analysis of the Potential Competitive Impacts of Basel II 
Capital Standards on U.S. Mortgage Rates and Mortgage Securitization,'' 
by Diana Hancock, Andreas Lehnert, Wayne Passmore, and Shane M. 
Sherlund (HLPS).
---------------------------------------------------------------------------
    I am concerned by reports that Basel II may result in significantly 
lower risk-based capital requirements for many of the largest U.S. 
banks. The Basel II process requires banks to calculate expected 
defaults and losses from these defaults. Regulatory guidance 
notwithstanding, it seems possible that Basel II banks' may use their 
experience over the past few very good years to make these assessments 
and this may lead a regulatory capital minimum that is too low in the 
case of bad times. My experience taught me that the minimal equity 
ratios prior to the banking crisis, then around 4 percent in large 
banks, were grossly inadequate for the problems that followed. At least 
two of our largest banks would have failed if there had been the 
slightest reduction in capital minimums. I do not know where Basel II 
capital levels will actually be, but I fear that using the 
extraordinarily benign recent period to calculate future risk will 
result in banks that are systematically undercapitalized when troubles 
arise.
    To their credit the regulators are saying they are not comfortable 
with these QIS-4 results and would not allow banks to operate at these 
levels of capital. The regulators indicate they will keep the leverage 
ratio and get around to fixing the Basel II formulas later.
    Maybe they will. Meanwhile, we are going to see a lot of screaming 
from U.S. banks because they are putting systems in place--at great 
expense--that will be, for most of them, irrelevant to determining 
their overall capital. U.S. financial institutions believe they are 
already constrained by our leverage ratio, unlike their foreign 
counterparts. The regulators do not believe low capital is a 
competitive advantage, quite the opposite. Our banks are not only well 
capitalized, but they also earn record profits year after year. But 
those banks who do measure performance by their current return on 
equity probably are going to believe we have given the rest of the 
world's banks a huge advantage.
    That is why I fear Basel II is putting in place a dynamic that 
cannot be controlled, and will ultimately lead to significant reduction 
in the capital of our banking system, and significantly increase the 
cost of the Federal safety net. I do not doubt the good intentions of 
the regulators today who say they will keep this process under control. 
However, they cannot control the actions of future agency heads. In 
addition, those agency heads are going to be under tremendous pressure 
because of what the regulators are doing today.
                               ----------

                 PREPARED STATEMENT OF WILLIAM M. ISAAC
         Former Chairman, Federal Deposit Insurance Corporation
                     and Chairman, The Secura Group
                           November 10, 2005

    Mr. Chairman and Members of the Committee, it is a distinct honor 
and privilege to appear before you today to discuss the implications of 
the proposed Basel II capital accord currently under consideration by 
U.S. regulators and those in other major countries.
    I will explain my rationale below, but let me say up front that I 
have grave reservations about the proposed Basel II capital regime. I 
believe it carries the potential to do enormous harm to the U.S. 
banking system, which is the strongest, most profitable, and most 
innovative banking system in the world.
    No regulator, legislator, or banker who lived through the banking 
crisis of the 1980's in this country can ever forget the lessons of 
that period--one of which is that capital very much matters. U.S. 
regulators and bankers have spent the last quarter century building the 
best banking system in the world. We should not risk everything we have 
worked so hard to create by relying on theoretical risk models to 
determine the appropriate level of capital for our banks.
    International regulators developed risk-based capital rules (called 
Basel I) in the late 1980's to apply to all banks. They offered two 
primary justifications for Basel I: (a) capital rules should apply 
uniformly to banks throughout the world in order to level the playing 
field, and (b) capital requirements should correspond to the level of 
risk in individual banks. One could hardly quarrel with these 
objectives, although it was far from clear that Basel I was the most 
appropriate way to achieve them.
    Despite its stated objectives, Basel I has not come close to 
fostering parity in worldwide capital standards. At year-end 2004, the 
20 largest banking companies outside the United States had a median 
capital-to-assets ratio of 3 percent compared to the 6 percent median 
ratio (excluding goodwill) of the 20 largest U.S. banking companies.
    The capital level of these foreign banks was below where the 
capital of large U.S. banks was in the late 1970's, before U.S. 
regulators began a major push to increase large bank capital levels. 
Only 2 of the 20 largest foreign banks met minimum U.S. standards at 
year-end 2004.
    Despite their overwhelming use of leverage, the median return on 
equity of these large foreign banks was comparable to the median return 
of major U.S. banks. In short, large U.S. banks have much stronger 
balance sheets and enjoy much higher operating margins than their 
foreign counterparts.
    Most career regulators in the United States were skeptical about 
Basel I from the beginning. They were reluctant to place too much faith 
in rigid formulas and doubted the claims that Basel I would bring about 
international parity.
    As a result of these concerns, U.S. regulators overlay on Basel I a 
minimum capital to assets standard (that is, leverage ratio) to guard 
against potential flaws in Basel I and to prevent capital from falling 
too sharply. Moreover, U.S. regulators retained the ability to override 
the Basel I standards and demand more capital whenever warranted. I 
have no doubt that the comparative strength of the U.S. banking system 
today is due in no small part to the fact that U.S. regulators did not 
succumb to the pressure to lower their regulatory standards to 
international norms.
    Almost from the day Basel I was adopted, the Basel Committee at the 
Bank for International Settlements began agitating for a more 
``sophisticated'' version of the regime, which has come to be known as 
Basel II. The rationale behind Basel II is that the largest banks in 
the world are too complex for the relatively simple capital standards 
of Basel I. Champions of Basel II believe the largest and most 
sophisticated banks have the ability to construct models to assign 
capital to their various risk exposures and that these models will be 
superior to any rigid tests the regulators might apply.
    Basel II is very controversial, as one might imagine. My major 
concerns about Basel II are that:

 Basel II is based on inadequate and unreliable data. No large 
    bank has detailed information on losses going back as much as 10 
    years. It is virtually impossible to build reliable models with 
    such a paucity of information, particularly when the decade that 
    the available information covers is the most prosperous in banking 
    history. Moreover, most of the large banks barely resemble what 
    they looked liked 10 or 15 years ago. They are amalgamations of 
    countless mergers of disparate cultures, businesses, and 
    information systems. How one could build a reliable model based on 
    the performance of a business that did not exist 15 years ago is 
    difficult to fathom. Adding to the confusion, Basel II expects 
    banks to build models for ``operational risks.'' There are two 
    categories of operating risks: (a) those you can predict, price, 
    and insure against, and (b) those that are not predictable. Losses 
    of the first type have never been a systemic problem in banking, 
    and losses in the second category cannot be modeled.
 Basel II will be used to reduce large bank capital ratios and 
    either place smaller banks at a competitive disadvantage or force 
    regulators to lower smaller bank capital ratios. Neither option is 
    acceptable public policy. The regulators conducted a Qualitative 
    Impact Study (QIS-4) on Basel II earlier this year, which produced 
    some very disturbing results. QIS-4 indicated that Basel II would 
    allow capital levels to drop by at least 26 percent at half of the 
    big banks, some falling by as much as 50 percent. The regulators 
    responded to this, in part, by rushing out with proposed revisions 
    to Basel I, which will presumably allow small-bank capital to 
    decline. Alice in Wonderland would love it, but no self-respecting 
    bank supervisor should. I do not believe a compelling case has been 
    or can be made for reducing capital in the banking system.
 Basel II is so complex it cannot be adequately understood by 
    senior bank managements, boards of directors, regulators, or the 
    public. I have been in the banking world all of my adult life and 
    served at the FDIC for nearly 8 years. Moreover, I have served on 
    the boards of three financial institutions. I think I know 
    something about what it takes to run a bank right and why banks 
    fail. The good ones have very good and experienced managements, 
    strong and independent boards of directors, and a healthy respect 
    for what can go wrong. They diversify their risks, put in place 
    strong control systems, maintain solid balance sheets, and are 
    always asking themselves what will happen if their assumptions are 
    flawed. Running a successful bank (and successfully regulating 
    banks) is an art that uses modeling and other forms of science as 
    tools. Basel II employs exceedingly complex models (constructed 
    largely by economists and mathematicians who have never made, much 
    less collected, a loan), which very few people in any bank or any 
    regulatory agency will understand. Making matters worse, Basel II 
    will likely foster complacency and a false sense of security, as 
    some bank managers and boards of directors and even some analysts 
    place unwarranted reliance on the models. If we allow Basel II to 
    elevate questionable science well above the art of management, 
    someday somewhere we almost certainly will pay a big price. We need 
    look no further than the debacle at Long Term Capital Management in 
    1998 to see what mischief can be caused by ``brilliant'' 
    mathematicians and Nobel Prize winning economists who are given 
    free rein to make huge bets based on their models. The Federal 
    Reserve found it necessary to pressure 14 banks and brokerage firms 
    to invest nearly $4 billion in new equity to prevent LTCM's 
    collapse and avert a possible panic in the worldwide financial 
    markets.

    All models, of necessity, look backward--that is, they use 
historical data to predict future events. They are accurate, most of 
the time, if properly constructed and manipulated. But they can result 
in spectacular failures when they are poorly constructed, use 
inadequate data, or rely on false assumptions.
    Large banks pronounced with great certitude in the 1970's and early 
1980's that loans to less developed countries were riskless because 
sovereign nations could not afford to default and thereby lose their 
access to international credit markets. Had Basel II existed then, I 
suspect the risk weighting assigned to sovereign debt would have been 
close to zero.
    I participated in serious and urgent interagency planning in 1984-
1985 on how to handle the potential simultaneous collapse of the 
largest U.S. banks in the event of widespread defaults on sovereign 
debt. Later in the 1980's Citibank, alone, charged off some $3 billion 
of LDC loans in one fell swoop. So much for theories and models.
    In important ways, Basel II is deja vu. The regulators developed a 
three-tier system for capital adequacy in the 1970's. Community banks 
were required to maintain capital equal to at least 8 percent of 
assets. Regional banks were allowed to go as low as 6 percent on the 
theory they were better managed and more diversified, and their size 
made them less vulnerable to catastrophic fraud losses. Money center 
banks had no minimum standard--they were OK so long as they did not get 
out of line with their peers.
    Believe it or not, the theory advanced by both banks and top 
regulators was that capital was not particularly relevant in banks as 
large and sophisticated as the money center banks. The typical money 
center bank had capital in the range of 3 percent during this period, 
with a couple falling below 3 percent.
    The FDIC, during my tenure, regarded it as fundamentally unfair to 
require smaller banks to maintain more capital than larger banks. Of 
even greater concern was the increasingly heavy reliance of larger 
banks on volatile money market sources of funding. We were concerned 
that at the first sign of trouble this money would flee, rendering a 
bank helpless. We believed that a strong balance sheet was of even 
greater importance in banks with volatile funding.
    The debate among banks and regulators was heated, not unlike today. 
The theories went out the window in 1984 when Continental Illinois, the 
eighth largest bank in the country, with one of the lowest capital 
ratios, lost nearly half of its funding virtually overnight.
    It was all the FDIC and Federal Reserve could do to stem the 
outflow and keep the infection from spreading to banks throughout the 
world. Together, these two agencies advanced in the range of $20 
billion to Continental Illinois, and the FDIC took the unprecedented 
step of guaranteeing that no creditor of Continental Illinois would 
suffer any losses or even any delay in receiving its money.
    Capital was no longer a theoretical exercise. The regulators 
quickly agreed that no bank, no matter how seemingly strong and well-
run, would be allowed to maintain less than 5 percent tangible equity 
to assets. Banks would be required to maintain capital above that level 
based on a case-by-case evaluation of risk through the bank supervisory 
process.
    Basel I was developed a few years later to quantify capital 
measures to a greater extent. While I have never been a fan of Basel I, 
at least U.S. regulators maintained a minimum capital to assets 
standard and Basel I did not discriminate based on the size of the 
bank.
    Some argue that a U.S.-imposed capital floor places U.S. banks at a 
disadvantage vis-a-vis foreign banks. This argument was advanced in the 
1970's and 1980's, particularly with respect to the Japanese banks, 
which were growing with reckless abandon and comprised nearly all of 
the 10 largest banks in the world. We hear little about the Japanese 
banks today, except that they are a drag on the Japanese economy. They 
operated with little capital, had very low profits, and pursued growth 
for growth's sake. This business model cannot be sustained 
indefinitely.
    I have not found a single professional bank supervisor who is 
enthusiastic about Basel II. For that matter, I have not found a single 
bank CEO who is enthusiastic about Basel II. Indeed, I have spoken with 
large bank CEO's who complain that Basel II is inferior to their own 
procedures, which give great weight to seasoned bankers using their 
judgment. They will implement Basel II if required to do so by their 
regulators, but they intend to continue to rely on their own models and 
procedures, which have withstood the test of time through various 
business cycles.
    Capital regulation, in my judgment, should be simple and easily 
understood. It is foolhardy to adopt a capital regime that will be 
virtually impossible for senior managements, boards of directors, 
regulators, and market participants to understand.
    There is nothing wrong with the current capital regime in the 
United States that cannot be fixed with some relatively simple 
modifications to Basel I. Moreover, it is critically important that the 
leverage ratio and other capital tests be maintained at their current 
levels.
    This is not to say that the Basel II exercise has been for naught. 
Basel II-type models no doubt provide useful information to the 
managements of banks and their regulators. Banks should be encouraged 
to develop and improve such models. But the last thing U.S. regulators 
should do is engage in a ``competition in laxity'' with supervisors in 
other countries by lowering U.S. capital standards to international 
norms.
    I thank you again for providing this public forum on one of the 
most profound public policy issues currently confronting our Nation's 
banking system.
                               ----------

                PREPARED STATEMENT OF GEORGE G. KAUFMAN
          Co-Chair, U.S. Shadow Financial Regulatory Committee
          and John F. Smith Professor of Finance and Economics
                       Loyola University Chicago
                           November 10, 2005

    Mr. Chairman, it is a pleasure to testify before this Committee on 
the public policy implications for the health and safety of the banking 
system and the U.S. macroeconomy of the proposed Basel II capital 
standards. My bottom line is that Basel II represents only minor 
improvement over Basel I as a public policy tool for enhancing 
financial stability in the United States and has the potential for 
weakening the more comprehensive structure that is currently in place 
in the United States.
    The Basel proposals will apply to banks (depository institutions) 
in both the United States and many other countries in order to achieve 
greater harmonization in capital standards among countries. If adopted 
in the United States, the proposal will be incorporated within our 
system of structured early intervention and resolution (SEIR), which 
includes both prompt corrective action (PCA) and a legal closure rule 
at positive capital at which point a bank is placed in receivership. 
But most other countries do not have such a system effectively in place 
and Basel needs to be evaluated on its own merits. For my remarks, I 
will focus primarily on the United States, but periodically refer to 
other countries.
    To evaluate Basel II objectively, it needs to be compared to an 
alternative structure for enhancing bank stability. Such an appropriate 
alternative is the system of SEIR, which was introduced in the United 
States in FDICIA in 1991 in response to its banking crisis of the 
1980's. Unfortunately, much of the discussion of Basel II in the United 
States has neglected to incorporate the existence of this structure.
    Basel and SIER/PCA have different histories. Each should be 
evaluated on the basis of what it was initially intended to do and not 
necessarily as a substitute for the other. Unfortunately, the different 
underlying histories often appear to be forgotten and each tends to be 
evaluated on a basis for which it was not primarily designed. 
Currently, in the United States, this confusion may be setting up a 
battle with possible serious adverse consequences for long-term 
financial stability. For the rest of the world, the proposed reliance 
on Basel may be taking attention away from developing more effective 
means of enhancing financial stability.
    Basel (the Basel Committee on Banking Supervision, which meets at 
the facilities of the Bank for International Settlements in Basel, 
Switzerland) developed in the 1970's from a need to facilitate the 
sharing of information among bank regulators and supervisors in 
different countries on internationally active banks operating in their 
countries, which were expanding rapidly (Herring and Litan, 1995). In 
large measure, this need was initially motivated by the large 
international costs related to the collapse of the medium-sized 
Herstatt Bank in Germany, that operated heavily in the foreign exchange 
market and lost. The bank was legally closed by the 
German authorities at the end of the business day in Germany after it 
received payments from its foreign counterparties, many of whose 
business day closed later, for foreign exchange transactions, but 
before it paid these counterparties at the end of their business day. 
Ironically, the international repercussions reflected primarily a 
regulatory and not a market failure. The timing of the closure 
effectively shifted losses from German depositors and the German 
deposit insurance agency to banks outside Germany. Basel's objectives 
were expanded in the 1980's to developing international capital 
standards to promote both safety among large internationally active 
banks in light of large losses from LDC lending and competitive 
equality across countries with respect to capital ratios. The latter 
was aimed particularly at Japanese banks, which were expanding their 
foreign market share rapidly on perceived very low capital bases. This 
was viewed as giving them a competitive advantage.
    The capital standards constructed in Basel I (1988) effectively 
resembled guidelines at the time for ``best practices'' in bank capital 
management, in particular with respect to incorporating credit risk 
exposures. Individual assets were weighted by one of four risk 
classification weights (buckets) and summed. The resulting risk-
weighted assets were then divided into capital to obtain risk-based 
capital ratios. The minimum suggested overall capital ratio for a bank 
was set at 8 percent, which most banks were then able to satisfy. But 
the scheme provided no provisions for enforcing this capital standard, 
replenishing shortfalls, or resolving an insolvent institution at least 
or even low cost. Thus, the usefulness of the structure for public 
policy was limited, although it did increase the sensitivity and 
knowledge of bank managers and bank regulators to measuring and 
managing risk.
    In contrast, in the United States at the same time, emphasis was 
not on developing best practices schemes for banks but on developing 
public policy measures to prevent a reoccurrence of the large-scale 
failure of thrift institutions and commercial banks in the 1980's, 
which imposed high cost on their insurance agencies and, for thrift 
institutions, also on the taxpayers (Benston and Kaufman, 1994). The 
structure was designed to turn troubled institutions around before 
insolvency, primarily through 
recapitalization or merger with healthier institutions, and, failing 
that, as a last resort to legally close and resolve them at lowest cost 
to the insurance agency and potentially taxpayers. This is to be 
achieved through increasing both market discipline and regulatory/
supervisory discipline.
    Market discipline was enhanced by increasing the number of de facto 
at-risk claimants through severely curtailing the use of the misnamed 
``too-big-to-fail'' (TBTF) policy--which, in reality, dealt not with 
failure but with protecting de jure uninsured claimants (Kaufman, 
2004b). TBTF was transformed into a harder to 
invoke ``systemic risk exemption'' (SRE). Supervisory discipline was 
enhanced by establishing SEIR with PCA, a legal closure rule at 
positive capital, and least cost resolution with enforcement provisions 
that affect both the regulators and the banks.
    Capital is the primary, but not the only, measure that triggers 
regulatory sanctions on troubled institutions, which are structured 
both to resemble the sanctions typically imposed by the market on 
floundering firms in nonregulated industries and to become 
progressively harsher and more mandatory as the condition of the bank 
deteriorates, culminating in legal closure and receivership. These 
provisions make it more difficult for regulators to forebear and force 
speedier actions to replenish capital if it declines below minimum 
target levels. Capital is viewed as the owners' funds that they ``have 
to play with''. The less capital, the more restrictive the game becomes 
and as capital approaches zero, the legal closure rule is invoked, the 
game is declared over, and least cost resolution is commenced.
    The usefulness of capital to absorb losses in this framework is 
related to the size of the bank. The usual measure of firm size is its 
total assets. Capital divided by the bank's total assets is the so-
called leverage ratio. Under FDICIA, PCA specifies three capital 
ratios--tier 1 (basically equity) leverage ratio, tier 1 Basel risk-
based ratio, and total capital Basel risk-based ratio--and five capital 
tranches or zones ranging down from ``well capitalized'' to 
``critically undercapitalized.'' (The major provisions are summarized 
in Table 1.) The minimum capital levels necessary to be classified 
``adequately capitalized'' are set at 4 percent, 4 percent, and 8 
percent for the three capital measures, respectively.
    The development of the Basel II was primarily motivated by a desire 
to correct two perceived weaknesses in Basel I. In the process, the 
number of pillars was expanded from one to three. The recommended 
changes are intended to:

 Enhance the accuracy of risk-based capital (Pillar I), and
 Introduce means for enforcing minimum regulatory capital 
    ratios (new Pillars II and III).

    But both improvements are relatively weak.
    Risk-based capital determined by market weights and forces is 
necessary for managing banks efficiently, but it is difficult for 
regulators to replicate accurately. The revised capital requirement in 
Pillar I attempts to do so for credit risk primarily for large banks. 
In the United States, with the approval of their regulators, these 
banks will be permitted to use their own internally generated credit 
risk ratings (including probability of default and loss if default) to 
compute their risk-based capital from a model provided by the 
regulators. (I will not comment on the Basel proposal for smaller banks 
or the recently modified proposal by U.S. regulators for most U.S. 
banks. Many of these banks maintain such high capital ratios that they 
will be effectively unaffected by these plans.) But, as has been 
discussed in a number of 
recent statements by the Shadow Financial Regulatory Committee, by 
increasing complexity, Pillar I does not necessarily make the 
regulation more accurate (Shadow 2000, 2002, and 2003). Increased 
complexity is likely, however, to both increase compliance costs and 
reduce understanding, particularly by the bank CEO, board of directors, 
and possibly even the CFO and by bank supervisors. Simplicity often 
trumps complexity in producing desirable outcomes through greater 
understanding. Furthermore if the risk weights are incorrectly 
selected, as is likely, the opportunity for gaming by the banks 
increases. Bank management and supervisors may be outgunned by highly 
technical Ph.D. model builders. The revision also introduces capital 
charges on a bank's operational risk for the first time.
    As noted, Basel II introduces two new pillars--Pillar II: 
Supervisory Review and Pillar III: Market Discipline--to increase the 
public policy usefulness of the structure (Kaufman, 2004a). However, 
Pillar II contains few specifics. It is intended to supplement Pillar I 
in determining appropriate capital for credit risk exposure and to 
expand regulatory concern to interest rate risk. But it focuses 
primarily on general principles and does not consider the wide 
variation in supervisory competence across countries. Most importantly, 
Pillar II contains neither mandatory PCA type measures to replenish 
capital and turn troubled institutions around before insolvency nor a 
legal closure rule and least-cost resolution provisions to guide the 
supervisors' actions. Much talk and little required action.
    Pillar III is not really about market discipline, but rather about 
creating transparency and disclosure. Mandatory disclosure would not be 
as necessary if there were more truly at-risk claimants, who would be 
expected to demand more transparency and exert more market discipline. 
Indeed, Pillar III would be far more 
useful in enhancing market discipline if it focused on increasing de 
facto at-risk claimants. This could be achieved by reducing the 
likelihood of invoking TBTF/SRE through making it more difficult to do, 
as in the United States since FDICIA, and by encouraging or requiring 
banks to issue truly at-risk subordinated debt (Shadow Financial 
Regulatory Committee, 2000). Nor does Pillar III introduce any cost-
benefit criteria to evaluate whether the benefits of each additional 
item to be disclosed exceeds the costs of collecting and processing it.
    As a result, Basel II provides only partial and flawed improvements 
over Basel I as a tool for public policy to achieve the goal of 
enhanced financial stability. Pillar I remains basically a ``best 
practices'' guide for internal bank management and not a public policy 
instrument.\1\ Indeed, while there is substantial empirical evidence of 
a negative relationship between leverage ratios and bank insolvency, 
there is no such evidence between risk-based capital ratios and bank 
insolvency (Evanoff and Wall, 2001). In no other industry do analysts 
compute risk-weighted assets or risk-based capital ratios for 
individual firms. But they do compute and investors use leverage 
ratios. Risk-weighted assets are an inferior scaler to total assets to 
gauge how much capital is available to a bank before the value of its 
assets declines below the value of its liabilities and it becomes 
insolvent. In sum, Pillars II and III are vastly inferior to PCA/SEIR 
with a strong legal closure rule at positive capital to minimize both 
the number and cost of bank failures.\2\
---------------------------------------------------------------------------
    \1\ Indeed, a recent article argues that the internal ratings model 
underlying the regulation is outdated even as it is being proposed 
(Thomas and Wang, 2005).
    \2\ A similar conclusion appears to have been reached by Goodhart 
(2004).
---------------------------------------------------------------------------
    Unfortunately, Basel II may be on the verge of causing major 
mischief in the United States that could weaken financial stability 
over the longer-term for large banks intending to use the advanced 
internal ratings approach. It appears that the 4 percent risk-based 
tier I capital requirement ratio can be achieved under Basel II for 
many of these banks with lower capital than currently is required both 
under Basel I and is required to be classified as an ``adequately 
capitalized'' bank according to the 4 percent tier I leverage ratio.\3\ 
Consequently, the leverage ratio is likely to become the binding 
constraint for these banks and prevent a reduction in required 
regulatory capital. The FDIC has recently concluded that ``U.S. 
policymakers will be confronted with a choice between ignoring the 
results of Basel II or substantially weakening the PCA requirements'' 
(FDIC, 2004). Although almost all U.S. banks currently maintain capital 
ratios at well above the regulatory requirements--indeed, the FDIC 
reported that bank equity capital ratios at midyear 2005 climbed to 
their highest level since 1939, more than twice the ratio required to 
be adequately capitalized--some banks appear to be lobbying U.S. 
regulators to lower the numerical threshold capital leverage ratio to 
qualify as adequately capitalized to below 4 percent, say to 3\1/2\ 
percent or lower. Congress in FDICIA delegated to the appropriate 
Federal regulators the setting of the numerical thresholds for all 
tranches but the minimum critically undercapitalized closure trigger of 
2 percent equity capital. Some large banks are also arguing that the 
current leverage ratio requirements put them at a disadvantage with 
their competitors in the rest of the world, who are not subject to 
these ratios.
---------------------------------------------------------------------------
    \3\ This occurs because 4 percent times a bank's risk-weighted 
assets yields a tier I capital number which, when divided by the bank's 
total assets, may be less the 4 percent.
---------------------------------------------------------------------------
    For U.S. regulators to cave in to such pressure in order to have 
Basel II adopted would be a big and costly mistake both for the U.S. 
macroeconomy and for the banks themselves. Considerable evidence 
suggests that even a 4 percent equity leverage ratio is lower than that 
maintained by almost all domestic nonbank competitors of banks, who are 
not similarly regulated nor covered by a safety net (Kaufman, 1992 and 
Kwast and Passmore, 1999). When industry leverage ratios decline below 
6 percent bank failures increase, particularly when the economy is in a 
recession. Indeed, on the whole, there is a negative relationship 
between leverage ratios and defaults in all industries (Molina, 2005). 
With respect to individual large banks, there is no evidence either 
that equity capital increases the bank's overall cost of funds or that 
there is an inverse relationship between bank capital ratios and bank 
return on either assets or equity.
    A time series analysis for U.S. banks shows a weak positive 
relationship between bank capital and profitability (Berger, 1995). A 
cursory cross-section analysis across the world's largest banks also 
shows a positive relationship between capital and profitability since 
the 1980's. Recently, United States, United Kingdom, Australian, and 
Spanish banks have both high capital ratios and high profitability, 
while German, Swiss, and Japanese banks have both low capital ratios 
and low profitability, although some adjustment may need to be made for 
the possibility of simultaneity in the direction of causation (Table 
2). Nevertheless, this helps to explain why capital ratios actually 
maintained by U.S. banks are considerably higher than the regulatory 
requirements. They are signaling strength to both depositors and 
borrowers. Among the largest 1,000 banks in the world in 2003, U.S. 
banks accounted for only 15 percent of aggregate assets, but 22 percent 
of aggregate tier 1 capital and fully 37 percent of aggregate pretax 
profits. For Japan and the EU countries, capital accounted for a lower 
percentage of aggregate capital for all 1,000 banks than did their 
assets as a percent of aggregate assets and profitability even less. 
For the remaining countries, capital was at least as high a percentage 
of the aggregate as were assets and was about the same percentage as 
profitability (Table 3).
    The results of the recent quantitative impact studies for large 
banks by the U.S. regulators raise concerns not only because they show, 
on average, lower regulatory capital requirements than currently but 
also because they show a large variance among individual banks. This 
suggests that the individual bank models generating credit risk weights 
may have flaws in construction and that they are very sensitive both to 
the quality of data available for each bank and to the sample time 
period over which they are empirically tested. The models may not yet 
be ready for prime time!
    In sum, adoption of Basel II for large banks in the Unites States 
is likely to have little effect on the banks and the economy if the 
current numerical threshold values for the leverage ratios for 
adequately and well-capitalized banks in PCA are not reduced and if 
market forces operate to maintain current capital ratios. If, however, 
because the new Basel II risk-based requirements can be met, on 
average, with lower leverage ratio numbers, the numerical definitions 
for adequately and well-capitalized banks were reduced, there are 
likely to be adverse longer-term consequences for both the banks 
themselves and the economy as a whole. The integrity of SEIR and PCA 
should not be compromised for the sake of harmonizing bank capital 
standards across countries.
    Adoption of Basel II by itself in other countries could undermine 
their adoption of better public policy structures and thereby increase 
both the likelihood and costs of financial instability. It is time, 
therefore, for these countries to reconsider the benefit-cost tradeoff 
of Basel versus a U.S.-type of structure resembling SEIR and PCA. But 
the Basel process has not been totally negative. It has greatly 
improved the measurement and management of risk by both bankers and 
regulators and thus enhanced financial stability worldwide. Basel 
should be maintained as an ongoing process to develop ever better bank 
best practices schemes for internal management purposes, but it should 
not be halted and put in place. It is the process, not the end result, 
that will provide the major benefits.



                PREPARED STATEMENT OF DANIEL K. TARULLO
              Professor, Georgetown University Law Center
                           November 10, 2005

    Mr. Chairman, Senator Sarbanes, I appreciate your invitation to 
testify today. I am currently Professor of Law at Georgetown University 
Law Center and the Nomura Visiting Professor of International Financial 
Systems at Harvard Law School. I teach, among other things, Banking 
Regulation and International Economic Law. At present I am at work on a 
book on Basel II. As you know, I held several economic policy positions 
in the Clinton Administration, ultimately as Assistant to the President 
for International Economic Policy. I testify today purely in my 
individual capacity as an academic, with no client interests or 
representation.
    Basel II would, if implemented, represent the greatest change in 
the regulation of commercial banks since the early 1980's. The savings 
& loan debacle that followed those changes is a cautionary tale of the 
potential for unintended and unanticipated consequences from any major 
regulatory change. Even policies that eventually prove worthwhile can 
entail significant transitional problems. In the case of the advanced 
internal-ratings-based (A-IRB) approach of Basel II, there are major 
additional grounds for concern: The complexity of the rules, the opaque 
manner in which they will be implemented, the absence of reliable 
information on the impact those rules will have on capital levels, and 
uncertainty on how the new regime will affect global financial 
stability.
    These and other difficulties have stretched the Basel II process 
years beyond the original target date for completion. They have also 
bedeviled efforts by bank regulators to implement into U.S. law the 
final Basel II rules, as released in June 2004. In late September, the 
agencies delayed once again their timetable for implementation. In 
their notice of delay, the agencies expressed their intention to issue 
a notice of proposed rulemaking early next year. My principal 
recommendation is that the agencies not proceed with an implementation 
regimen unless and until they are able to answer more convincingly the 
basic questions surrounding the impact of Basel II--most importantly, 
its effect upon minimum regulatory capital levels.
    Because Congress has previously given the banking agencies broad 
authority to regulate bank capital levels, no legislation is needed to 
implement this international arrangement. But, as the regulators have 
already been responsive to the concerns of banks throughout the Basel 
II process, one would hope they will be at least as responsive to a 
considered request for caution by Congressional committees of relevant 
jurisdiction.
    While delay will understandably upset those financial institutions 
that have 
prepared for Basel II in anticipation of substantial reductions in 
their capital requirements, there is no compelling reason to brush 
aside the important unanswered questions. Our banks today are sound and 
they are profitable. There is no crisis requiring action in the face of 
incomplete information. While it is certainly important to encourage 
large banks to adopt the best available methods for risk management, 
this is insufficient justification for a leap into the unknown on 
capital requirements. As I explain in the next section, capital 
requirements have become so central to prudential bank regulation that 
proposals for significant change should be subjected to the full 
scrutiny and debate that would accompany any major modification of 
government policy.
    In the remainder of my testimony I will first review the key role 
played by capital requirements in prudential bank regulation, next 
identify the goals that the Basel Committee has itself set for the 
revised Accord, and then discuss my doubts that Basel II will realize 
these goals. Finally, I will elaborate my reasons for counseling 
caution and suggest some steps this Committee might take to assure that 
Basel II does not compromise the safety and soundness of large banks, 
both in the United States and abroad.

The Importance of Capital Regulation
    Regulatory monitoring of bank capital levels has existed in the 
United States since at least the early years of the twentieth century. 
Although the sophistication of that monitoring evolved fairly steadily, 
explicit minimum capital requirements were not imposed by U.S. bank 
supervisors until the 1980's. In the intervening years, capital 
requirements have become central to prudential regulation. As a result, 
the complete overhaul of capital regulation contemplated in Basel II is 
of greater significance to the safety and soundness of the U.S. banking 
system than the Gramm-Leach-Bliley Act or, indeed, any other 
legislation since the Federal Deposit Insurance Corporation Improvement 
Act of 1991 (FDICIA).
    Bank capital is generally thought to play three interconnected 
roles. First, it provides a buffer against bank losses arising from bad 
loans or any other cause. Capital reserves permit the bank to absorb 
these losses without becoming insolvent. Second, capital mitigates 
creditor losses if the bank nonetheless fails. Third, capital holdings 
create a disincentive for banks to take excessive risks. If a bank has 
low or zero capital, its owners and managers will be tempted to put the 
funds available from deposits toward risky, but potentially high-
return, uses. They have literally nothing to lose. The higher the 
bank's capital levels, the more they have to lose, and thus the more 
prudent their lending policies should be.
    These effects of capital can be found in any corporation, but the 
government usually does not require minimum capital levels in 
companies. We generally leave it to those who lend money to 
corporations to find ways to protect themselves. Where banks are 
concerned, however, there are powerful reasons to regulate capital 
levels. The existence of federally insured deposits means that the 
government is, in effect, one of the biggest creditors of most banks. 
Since the premiums charged for deposit insurance are not in any strong 
sense calibrated for the riskiness of the bank, capital requirements 
serve as a substitute to protect the FDIC, and ultimately American 
taxpayers.
    In addition, there is a widespread perception in financial markets 
that many large banks are considered ``too big to fail'' by bank 
supervisors. Bank failures can in some instances lead to much greater 
harm to the economy as a whole than the bankruptcy of even the largest 
nonfinancial corporations. Most important, of course, is the 
possibility of a systemic effect, in which the failure of one large 
bank produces dislocations that reverberate through the financial 
system. In the worst case, the result could be a freezing up of credit 
availability and thus a shock to the economy. Creditors of banks 
thought to be too big to fail may not insist on high enough levels of 
bank capital because they believe that the Federal Reserve Board will 
bail out a very large bank before it becomes insolvent. Capital 
requirements help compensate for this form of moral hazard effect.
    There is nothing particularly new in the role that regulatory 
capital can play. What is relatively new is the reliance placed on 
capital regulation to assure bank safety and soundness. For half a 
century following Depression era reforms, banks were quite 
circumscribed by legal restrictions and technological limitations. The 
activities they could engage in, the interest rates they could pay 
depositors, and the places where they could do business were all 
severely constrained. Banks were, in an important sense, protected from 
themselves, or at least from any inclination they might have to take 
business or financial risks. They were also the beneficiaries of a more 
or less guaranteed market for their services as financial 
intermediaries between savers and users of capital.
    Changes in the financial environment, such as the expansion of 
capital markets and the rapid growth of money market funds, provided 
vigorous competition to banks at both ends of their business. What 
followed is well-known. Geographic, interest rate, and activities 
restrictions were all relaxed or eliminated. Banks undertook new 
activities and many took more risks in their traditional lines of 
business. There ensued some fairly dramatic problems, notably the 
weakening of large money center banks during the Latin American debt 
crisis of the early 1980's and the S&L crisis later in the decade. If 
the safety and soundness of banks were to be ensured, a new approach 
was obviously needed. Congress decided upon capital regulation in the 
wake of the Latin American defaults and, in FDICA, built on that 
approach by mandating the important practice of prompt corrective 
action. Regulators in many European countries had already implemented 
various forms of risk-based capital requirements.
    Today, we rely on capital regulation as the most important single 
element of bank regulation. We use capital levels to determine when 
supervisory intervention is required. We use capital levels to decide 
when banks are strong enough to engage in the nonbanking activities 
permitted by Gramm-Leach-Bliley. And, of course, we rely on capital 
levels to provide a buffer against loss and insolvency from the complex 
and varied activities of a large, modern bank.
    This very brief survey of the role and history of capital 
regulation is, I hope, sufficient to show the importance of knowing 
with some certainty the impact of the proposed regulatory changes 
before actually adopting them. It is never possible to predict all the 
effects that a new regulatory scheme will have but, the more important 
that scheme is to ensuring a social good as important as bank safety 
and soundness, the more we should know before it is prudent to proceed.

The Basel II Process
    The first Basel Accord on capital adequacy had two aims: First, to 
increase the stability of the international financial system by 
ensuring that internationally active banks had sufficient capital 
cushions. This arose directly from the travails of U.S. and other banks 
arising from the Latin American sovereign debt crisis. Congress had 
insisted that, in exchange for the partial bail-out these banks were to 
receive through IMF assistance to the defaulting sovereigns, the banks 
be required to increase their capital levels. Regulators in a number of 
other countries shared a concern that the capital levels of many large 
banks were too low. Second, the Accord was intended to promote greater 
competitive equality among internationally active banks from different 
countries. American and British banks in particular believed that the 
more generous safety nets for banks provided by the Governments of 
Japan and France gave banks in those countries access to private 
capital at a lower cost. As noted earlier, bank creditors who believe 
that the borrowing bank will be saved from insolvency by its government 
will demand a lower risk premium in their lending to that bank. With a 
lower cost of funds, the bank will in turn be able to lend profitably 
at lower rates than its competitors from countries with less generous 
safety nets.
    To what degree were these aims realized? It is difficult to isolate 
the effects of Basel I, as implemented around the world, from economic 
conditions, market developments, and other regulatory factors. 
Regulators in the Basel Committee countries were already converging 
around the view that risk-based capital requirements should be an 
important element of bank regulation. Thus, Basel I essentially 
ratified and harmonized a regulatory trend; it did not initiate a major 
regulatory change. Whatever the reasons, it is indisputable that 
capital levels rose following adoption of the Accord. In the 
intervening years, large international banks have remained remarkably 
sound, despite two international financial crises and rapid change in 
financial services industries. The major exception, of course, has been 
the Japanese banking system, but the origins of its problems 
considerably predated implementation of Basel I.
    There is little reason to believe that the Accord has, to any 
significant extent, created the proverbial level playing field among 
internationally active banks. We do not have the benefit of 
comprehensive empirical work on this question. Still, on the basis of 
some limited work on the question, several scholars have concluded 
that, in all likelihood, national differences in tax, accounting, and 
other regulatory measures outweigh any leveling achieved by harmonized 
minimum capital standards. This is not to say that such standards have 
no effect on the competitive position of banks--only that it is 
probably modest compared to other factors.
    The shortcomings of Basel I have been well-rehearsed throughout the 
Basel II process, and I need not repeat them in detail today. Suffice 
it to say that the possibilities for regulatory arbitrage prompted the 
Basel Committee to undertake a substantial revision of the original 
Accord in the late 1990's. Its first effort, released in 1999, was 
roundly criticized by large banks and others as sharing many of the 
same flaws as Basel I. Subsequently the Committee completely reoriented 
its work, producing the Advanced Internal Ratings Based (A-IRB) 
approach to capital regulation. In the course of this shift, the 
Committee adopted an additional aim for Basel II--to bring regulatory 
capital requirements more in line with the quantified credit risk 
assessment and management practices of many large banks. U.S. and other 
supervisory agencies on the Committee had concluded that the complexity 
of banking transactions and the speed with which the creditworthiness 
of counterparties may change had rendered Basel I anachronistic. 
Supervisors commented that the Basel I capital requirements were based 
on such crude assessments that they really did not provide a useful 
picture of the risk profile of a large, complex bank.
    It is important to note that, in reorienting the revision of the 
Accord toward basing regulatory capital requirements upon banks' 
internal credit modeling, the Basel Committee repeatedly emphasized 
that its goal was neither to raise nor to lower the aggregate level of 
regulatory capital in the banking system.
    The regulatory agencies that constitute the Basel Committee--
including U.S. supervisors--have thus identified their purposes for 
internationally harmonized minimum capital requirements: (1) stability 
in the international banking system, to be achieved through minimum 
capital levels that reflect (2) a closer alignment of regulatory 
capital with the ``economic'' capital determined by banks themselves on 
the basis of sophisticated risk management systems to be optimal for 
their situations, which (3) does not result in significant changes in 
aggregate levels of regulatory capital, while (4) promoting competitive 
equality among internationally active banks. My misgivings about the 
process arise in substantial part because, at this juncture at least, 
Basel II does not stack up well against these stated aims.

Unanswered Questions Concerning Basel II
    Earlier in my testimony I referred to the savings & loan debacle of 
the 1980's. Let me emphasize that I do so not because I predict that 
implementation of Basel II would lead to a comparable calamity, but 
because that episode is an object lesson in the potential for 
unintended and unanticipated consequences resulting from major 
regulatory change. Even the most thorough analysis cannot eliminate 
completely the possibility for such consequences. But, in the absence 
of pressing 
circumstances that require a response to deal with an immediate threat, 
major regulatory change should generally proceed only after analysis 
has yielded a reasonable degree of confidence as to the likely effects 
of that change. In the case of Basel II, I believe that we are not at 
that point of reasonable confidence. To the contrary, some of what we 
do know gives additional grounds for concern.
    Uncertainty as to Impact on Capital. The matter can be stated 
simply: As we sit here today, no one knows what the impact of the Basel 
II formulas will be on the regulatory capital requirements applicable 
to the large banks that will adopt the A-IRB approach. Each time U.S. 
banking supervisors have performed a so-called Quantitative Impact 
Study (QIS) to attempt an assessment of these effects, the results have 
surprised them. The latest of these exercises, QIS-4, suggested that 
minimum capital levels would fall by at least a quarter, and in some 
cases much more, at half the bank holding companies participating in 
the study. This clearly was not the result the Federal Reserve Board 
expected.
    Let us be clear. I am speaking here not about unintended 
consequences of regulatory change, such as shifts in market behavior of 
regulated entities. I am speaking of the intended and direct 
consequences of the new rules upon the amount of capital the banks must 
hold. The inability to determine what minimum capital levels will 
actually be required under the A-IRB approach is a major reason why, on 
September 30, the banking agencies again delayed the implementation 
schedule for Basel II in the United States. Yet, even as they announced 
the delay, the agencies indicated their intent to move forward with 
implementing regulations early next year. In an apparent effort to 
reassure those of us concerned that capital levels will decline 
significantly under Basel II, they also indicated that they will limit 
the amount by which minimum capital can decline in the first 3 years 
that Basel II is in effect. Finally, the banking agencies state that a 
bank's primary Federal supervisor will decide whether to terminate the 
capital floors at the end of the transition period.
    At present, then, the position of the banking agencies is 
essentially as follows: We do not really understand what the impact of 
the Basel II formulas will be on minimum capital levels, but we think 
the only way we will find out is to implement the new rules. We will 
not let regulatory capital fall too quickly in the first few years. 
After that, we will take a look at what happens and, if we see the 
need, instruct banks to hold higher capital levels than the Basel II 
formulas would require.
    This plan is at best premature. It might be defensible if the 
overall impact of the regulatory change were broadly understood, with 
some second-order effects unclear based on the test runs. Here, though, 
the banking agencies cannot say what the most basic impact of the Basel 
II rules will be. The agencies may respond that they can raise increase 
minimum capital levels down the line if capital appears to be dropping 
too much. In the present context, this argument is not persuasive. The 
very determination of the Fed, in particular, to proceed with 
implementation in the face of all doubts and uncertainties leads one to 
question whether the agencies would admit errors and effectively 
supersede Basel II in a few years. Moreover, one must expect that the 
large banking organizations would vigorously oppose any move to, as I 
am sure they would put it, increase their capital requirements above 
what their credit risk models indicate is necessary.
    The presumption, I believe, should run in the other direction. 
Implementation should not proceed until the impact and implications of 
Basel II are much better understood, and have been much more thoroughly 
vetted. It is hardly unreasonable for Congress and the public to expect 
that there be at least one impact study that bears out the expectations 
and predictions of the banking agencies before they proceed with 
implementation.
    Questions About Credit Risk Models. The inability to specify the 
effects of Basel II formulas on regulatory capital is of even greater 
concern in light of the anticipated reliance on credit risk models as 
the basis for determining minimum capital levels. The concern arises 
both from the technical state of credit risk models and from the 
supervisory challenge in overseeing the use of those models.
    Credit risk modeling is a relatively new undertaking, at least in 
its comprehensive form. Any model is, of course, only as good as its 
inputs. If the credit risk parameters supplied by banks are unreliable, 
even a well-constructed model will give a misleading picture of actual 
risk. One difficulty is the potential for intentional distortion of 
model input. Even assuming good faith on the part of the banks, the 
relative dearth of useful historical data is cause for concern. There 
is generally less than a decade's worth of historical data available 
from which to generate the values incorporated into the model. 
Additionally, it is considerably more difficult to backtest credit risk 
models than market risk models. While the prices of traded securities 
change daily, defaults are relatively unusual events and tend to occur 
in clusters because of adverse macroeconomic conditions. Because there 
has been no serious recession during the last decade, there has been 
little opportunity to stress test the models.
    The banking agencies have acknowledged that even the credit risk 
models used at the largest banks do not yet possess the 
``sophistication and robustness'' that would be necessary to rely upon 
them for regulatory purposes. Basel II takes account of the relatively 
undeveloped state of the art of credit risk modeling by imposing its 
own formulas into which only four bank-generated variables are fed 
(probability of default, the bank's exposure at default, expected loss 
if default occurs, and the maturity of the asset). Yet even oversight 
of this process presents a new kind of supervisory challenge. The 
complexity of, and differences among, bank models will require a highly 
specialized expertise within the banking agencies in order to oversee 
compliance of A-IRB banks with their capital requirements. The banking 
agencies have assembled teams of experts to supervise the 
qualification, implementation, and operation of models in the A-IRB 
banks. To my knowledge, though, the agencies have not provided detailed 
information on the numbers of experts they have employed or projections 
as to how many bank models the teams will be able to examine before 
they are stretched too thin.
    Questions about the ability of our banking agencies to supervise 
the use of internal credit models for regulatory capital calculations 
naturally raise the question of who can monitor the supervisors. The 
difficulties raised by the complexity of the bank models are compounded 
by the fact that much of the information contained in the models will 
be proprietary to the bank. Congress, academics, and other interested 
observers will thus not be in a position to assess how good a job the 
banking agencies are doing. Nor will creditors of banks be able to make 
their own informed assessment of the bank's risk and capital position, 
thereby limiting a source of market discipline that might contribute to 
bank safety and soundness. Finally, the opaque nature of the 
supervisory process for internal credit risk models means it is not 
clear whether and how U.S. banking agencies will be able to determine 
if their foreign counterparts are effectively supervising their own A-
IRB banks. Basel II would hardly be contributing to even the limited 
equalization of competitive conditions that can be effected by capital 
requirements if those requirements are not being rigorously enforced in 
some countries.
    There are no easy solutions to these difficulties. It is perhaps 
understandable that, after years of work, the regulators have grown 
impatient with the seemingly endless technical challenges and want to 
get on with implementation, making further needed changes as they go 
along. However, in my judgment, there are still too many questions 
outstanding for the agencies to proceed.
    A Downward Spiral for Capital Levels? The problem, of course, is 
not just that the agencies cannot say what the effects of Basel II will 
be. It is also that such indications as we have from the imperfect 
impact studies suggest that capital levels could decline significantly. 
Recall that the Basel II process began with assurances from the 
supervisors that aggregate capital levels would not decline 
significantly. It appears that this assurance has been abandoned by the 
supervisors. Instead, about the only thing we can be sure of is that 
the A-IRB approach would produce significant declines in regulatory 
capital.
    Indeed, the Basel II process seems to have acquired a disturbing 
capital-reducing momentum. Large banks appear to regard Basel II as an 
agreement between the banks and the regulators, whereby the banks will 
make the investments necessary to qualify for the A-IRB approach and 
the regulators will reduce required capital levels. I note with some 
concern that, when the European Parliament was considering new capital 
regulations based on Basel II, at least one European Commission 
official was reported to have touted the benefits of reduced capital 
requirements for European banks of between =80 billion and =120 billion 
(approximately $94-$141 billion at current exchange rates).
    After seeing the risk weights that will be applied to residential 
mortgage and small business lending under Basel II, the 9,000 U.S. 
banks that will not be applying the A-IRB rules became concerned that 
they will be disadvantaged in competing with the A-IRB banks in those 
lending markets. Their complaints have prodded the agencies to proceed 
with plans for a so-called Basel I-A for all but the largest twenty or 
so banks that will adopt A-IRB. Existing capital rules based on Basel I 
will be modified to provide more ``risk sensitivity''--a euphemism for 
reduced capital requirements--for these categories of loans. The 
banking agencies' advanced notice of proposed rulemaking provides only 
possible means to this end, rather than a concrete proposal. 
Ironically, some of the ideas advanced by the agencies are contained in 
the ``standardized approach'' of Basel II--a revision of the original 
Basel I approach that U.S. regulators had previously rejected as 
insufficiently risk-sensitive to be worth implementing. While we do not 
know exactly where this process will eventually take the banking 
agencies, it is clear that reductions in minimum capital requirements 
will be the result.
    The Basel I process began out of concern that capital levels at 
many internationally active banks were too low. In the years following 
adoption of Basel I, capital levels did generally increase. The Basel 
II process began out of concern that capital holdings may not be 
sufficiently related to actual risks incurred, particularly in large 
complex banking organizations, but with the stipulation that aggregate 
capital levels would not change significantly. What we seem to be 
getting is a kind of downward spiral in capital levels--large banks 
expect reduced regulatory capital requirements in exchange for more 
complicated risk assessment systems; changes are made in the Basel II 
formulas that appear to reduce capital requirements; banks that will 
not be adopting the A-IRB approach seek, and are granted, lower capital 
requirements in order not to be at a competitive disadvantage with the 
large banks; meanwhile, the large banks see Europe moving ahead with 
Basel II implementation under the promise of lower capital levels and 
do not want to be left behind. Federal Reserve Board officials even 
suggested last spring that simple leverage ratios would eventually be 
eliminated, thereby lowering capital requirements even further for 
banks whose risk-weighted requirements will drop substantially under 
Basel II. While the Fed backed off this position following an outcry 
from Members of Congress, the floating of this proposal showed the 
momentum that has been generated for reducing capital levels.
    This momentum is all the more disturbing because the regulators 
have not given us any explanation of why they believe capital levels 
should be lower than at present, if indeed they believe so. Capital 
requirements reflect a judgment as to the optimum trade-off between 
making more bank resources available for investment in productive 
activities and the costs that will be borne by the public fisc and the 
economy if banks fail (or are propped up by the government so as not to 
create problems in other parts of the financial system). This trade-off 
is a policy judgment; it cannot be reduced to a formula. In some 
respects, the judgment is based on the intuition of those with 
knowledge and experience of banks and banking systems. The bank 
regulatory agencies have not explained their theory of where capital 
levels should be, and why. Instead they have focused mostly on 
technical issues. They leave those of us observing the process worrying 
that the overriding goal of the Basel II process has become simply 
getting the new rules in place.

Some Practical Steps Forward
    While I share the skepticism of many academics and former 
policymakers that the A-IRB methodology of Basel II is the best 
approach to capital regulation, I cannot say today that I have 
concluded it should be abandoned. However, there are simply too many 
important unanswered questions--theoretical, policy, and practical--to 
make proceeding with implementation a prudent course of action. My core 
recommendation to you is that Members of Congress urge the banking 
agencies not to proceed with implementation until at least the more 
important such questions have been satisfactorily answered:

 Do the agencies believe that, in general, minimum capital 
    levels are too high and, if so, what is the basis for that belief ?
 Have the agencies been able to predict with reasonable 
    precision the levels of capital that the A-IRB approach will 
    require of large banks, and then to confirm their prediction 
    through studies that are well-conceived and executed?
 Have the agencies done scenario planning to anticipate the 
    effects, unintended and otherwise, of Basel II upon the financial 
    system as a whole? For example, are significant portions of certain 
    kinds of assets likely to migrate out of banks into the unregulated 
    sector? If so, might new risks of financial disruption be created?
 What do the agencies regard as the effective capacity of the 
    specialized examiner teams that will be overseeing the use of bank 
    models under A-IRB? How will the agencies determine whether other 
    countries are successfully monitoring bank capital levels under the 
    A-IRB approach?
 Have the banking agencies consulted with institutional 
    investors, ratings agencies, independent analysts, and other market 
    actors concerning the amount of 
    information about their credit modeling that A-IRB banks will be 
    required to disclose?
 Do the banking agencies continue active study of alternative 
    approaches to capital regulation, such as the varieties of 
    proposals based on market discipline or on so-called precommitment? 
    I add this question because, although I do not believe that any of 
    those approaches is at present appropriate as the sole basis for 
    capital regulation, I cannot but wonder whether devoting some of 
    the time and resources spent on developing the A-IRB approach might 
    have revealed workable variants of other ideas. It seems to me that 
    we should continue to explore these and other alternatives since, 
    as many experienced observers believe, the A-IRB approach may not 
    ultimately prove feasible.

    It may well be that the agencies already have good answers to some 
of these questions, in which case they should be able to satisfy some 
of these concerns fairly quickly. With respect to the core issue of 
what capital levels will result from the Basel II rules, I believe that 
more work almost certainly needs to be done.
    I have one other suggestion for you to urge upon the banking 
agencies if and when Basel II is implemented. The heart of the A-IRB 
approach involves using banks' internal estimates of the probability of 
default and a few other variables as the basis for risk-weighting 
minimum capital requirements. As mentioned earlier, there is not much 
of a track record on how accurate the predictions will be, especially 
in a time of economic turbulence. It will thus be important to 
rigorously and thoroughly evaluate the performance of the models on an 
ongoing basis. While I expect that the banking agencies will themselves 
pay heed to this subject, it would be useful for all concerned that 
there be an independent examination of this critical issue. Banking 
agency staff with credit model expertise will presumably be fully 
occupied in supervision, and will not have time for a complete 
assessment of past performance. In any case, it will be reassuring for 
Congress and the public to have an independent evaluation to complement 
the views of the banking agencies. Just as Congress has urged, and even 
mandated, evaluations of the efficacy of certain government spending 
programs in accomplishing their stated aim, Congress should encourage 
the banking agencies to contract with expert outsiders to conduct 
periodic evaluations of the bank models and of the supervisory 
requirements for the A-IRB banks.

Conclusion
    Banking agencies in the United States and other Basel Committee 
countries have invested an enormous amount of work in the Basel II 
process. There is little question but that, as a result of this effort, 
we understand far better the challenges of risk management and 
prudential regulation in large banks operating in the financial 
services environment of the 21st century. It is clear, to me at least, 
that the Basel I standards cannot indefinitely remain a viable method 
of capital regulation. But that does not mean they should be abandoned 
before we have enough information to know that their replacement will 
be a net improvement. The mere fact that so much has been invested by 
the banking agencies in the A-IRB approach is not itself a 
justification for moving forward. Indeed, the accomplished economists 
who work in those agencies should know better than most of us the old 
economic axiom that the sunk costs you spent yesterday should not 
affect your assessment of the best way to spend additional resources 
going forward.
    There needs to be more information developed by the agencies and 
more public debate on the central questions concerning Basel II before 
we make such dramatic changes in the regulation of our largest banks. 
It is noteworthy that the leadership of all five of the key 
institutions has turned over, or is in the process of doing so, since 
the Basel II process got underway in earnest (I include the Federal 
Reserve Bank of New York as a key actor, in addition to the quartet of 
the Federal Reserve Board, the Office of the Comptroller, the Federal 
Deposit Insurance Corporation, and the Office of Thrift Supervision.) I 
am hopeful that the new leadership is well-positioned to build on the 
work that has been done, while heeding the concerns of this Committee 
and others, to formulate sound and effective capital policies for all 
our banks.
    Thank you for your attention. I would be pleased to answer any 
questions you might have.
                               ----------

                PREPARED STATEMENT OF KATHERINE G. WYATT
                Head, Financial Services Research Unit,
                   New York State Banking Department
                           November 10, 2005

    Good morning, Chairman Shelby, Senator Sarbanes, and Members of the 
Committee. My name is Katherine Wyatt. I head the Financial Services 
Research Unit at the New York State Banking Department. I have followed 
the development of Basel II for the Department since 2000, studied the 
possible effects of the simpler approaches under Basel II, and worked 
with my Federal counterparts in analyzing banks' implementation 
programs for Basel II. I appreciate the opportunity to testify today, 
and ask that a copy of my written statement be included in the record.
    I am speaking to you today because I am very concerned that 
adhering to the proposed timetable for implementation of Basel II in 
the United States will lead to far-reaching changes in the how we 
measure capital without sufficient understanding of their possible 
consequences.
    Although the New Basel Capital Accord (Basel II) has been discussed 
in the United States since 1999 (at least) there has been insufficient 
study of its impact on the U.S. banking system, in part because the 
proposal itself has changed over time, and in part because the Federal 
banking agencies decided to restrict its implementation to the most 
complex approach and to impose it on only the largest internationally 
active banking organizations. For example, the best study we have, the 
fourth Quantitative Impact Study, involved about 20 large 
internationally active banks and used a version of the Basel II 
proposal that did not have important details that have been promised 
for the Basel II NPR, due in Q1 2006.
    The banking system in the United States comprises about 9,000 
different institutions and is rich in different-sized banks with 
different business models. Because we have only considered Basel II in 
terms of large complex internationally active institutions, we do not 
know what the competitive impact of Basel II will be. We do not know 
what the effect of large banks calculating capital requirements one 
way, while smaller banks in the same market calculate requirements 
another way will mean. We do not know what the effect on smaller banks 
that are public companies and are concerned with return on equity will 
be if their competitors are allowed to hold less capital. We must carry 
out a comprehensive impact study--across the entire banking system--
before regulations are adopted that could have far-reaching effects for 
banks and their borrowers.
    The Federal agencies plan to finish the rulemaking process for 
Basel II, conduct a year of parallel run of current requirements and 
Basel II, and to have Basel II in effect, all by January 1, 2009. They 
also aim to have the Domestic Capital Modifications for non-Basel II 
banks (Amended Basel I) in effect on January 1, 2009. I am afraid that 
pushing ahead to complete the rulemaking process for two complex 
proposals in less than 3 years will not allow time for essential review 
of either.
    The Basel II Notice of Proposed Rulemaking will have been in 
development for 2\1/2\ years when it is released; we need sufficient 
time to study this complex proposal. It will be very important to look 
at Basel II and the Amended Basel I 
proposals side-by-side, and to study their impact on the U.S. banking 
system. I am concerned that supervisors will not have enough time to 
consider the possible consequences of these sweeping changes before 
they become effective--and before revision is much more difficult.
    It is true that the agencies have included 3 years of ``floors'' in 
their implementation schedule. There will be graduated limits on 
capital requirements, and banks will be able to move fully to Basel II 
only at the end of these ``floor'' years. However, I believe it will be 
very difficult to make fundamental changes in Basel II after the 
January 2009 effective date. Banks that adopt Basel II in 2009 will 
already have made substantial investments in systems and data 
collection processes, and will surely object strongly to making changes 
after the effective date.
    The Agency projection also assumes that all the necessary 
documentation for supervision of banks following these revised 
regulations--guidance, reporting requirements, and examination 
procedures--will be developed in this very short period of time.
    I believe that there are two large gaps in our understanding of the 
impact of Basel II that must be addressed before we move to a Final 
Rule for either Basel II or Amended Basel I.
    First, we do not know what the actual level of capital will be 
under Basel II for any given bank, or across all Basel II banks. 
Preliminary QIS-4 results showed a broad range of required capital 
amounts, even for similar portfolios. Also, Basel II has changed over 
time; the agencies' timetable seems to involve going ahead with 
implementation without an impact study of the fully specified proposal. 
Even more importantly, since capital requirements under Basel II are 
based on outcomes of mathematical models, we need time to develop 
rigorous technical guidelines for parameter estimation and tests of 
data sufficiency, to ensure that required levels of capital are 
adequate.
    The second large gap in knowledge comes from the fact that we have 
not addressed the changes that may be brought by Basel II (and Amended 
Basel I) across the entire banking system. Basel II's impact in the 
United States has been studied primarily on large complex banking 
institutions. However, we have not fully studied the competitive effect 
of Basel II on the close to 9,000 non-Basel II banks in the United 
States. The Amended Basel I proposal for non-Basel II banks was 
released only last month, and it is essential that the effects of these 
two proposals be studied side-by-side.

Use of Models in Calculating Capital Requirements
    I would like to speak first about banks' Basel II capital 
calculations. Under Basel II, capital requirements for credit exposures 
are based on the outcomes of a particular mathematical model of default 
specified by supervisors. This supervisory model is applied to 
complicated portfolios, with a host of adjustments, specifications, 
exclusions, and exceptions that grew out of attempts to reconcile the 
model results with existing bank portfolios and existing international 
bank regulation. (The final U.S. version of these adjustments and 
specifications should be released early next year.) Basel II banks 
provide their own estimates of probability of default, loss given 
default, exposure at default, and maturity as inputs to the Basel II 
formulas; these parameter estimates depend on the data and other models 
used by the bank.
    A key premise of implementation of Basel II is that banks will have 
enough reliable data to produce rigorous results from the model. I 
think many would agree with me that this is often not the case. The 
variation in required capital estimates for similar exposures found in 
QIS-4 is quite possibly due to problems of insufficiency of data. We 
also need to make sure that the modeled capital requirements are 
adequate when times are bad--the history of the last several years in 
the United States is of good times.
    In contrast to the treatment of credit risk, Basel II allows banks 
to choose their own model to calculate capital requirements for 
operational risk. Here, even more variation in results is possible, 
particularly since there are even fewer data for operational loss 
events than for credit losses. The Basel II ANPR advises banks to use 
``expert opinion'' scenarios to fill out data points in their modeling, 
thus providing even more opportunities for selection in modeling 
techniques.
    Unfortunately, Basel II could be gamed by choosing the modeling 
techniques and data sets that will produce the lowest capital 
requirements. As well as a very broad range of required capital, 
preliminary QIS-4 results showed decreases as great as 74 percent for 
some bank portfolios. The strong possibility exists, also, that as the 
distance between risk-based capital requirements and current leverage 
ratio under prompt corrective action (PCA) capital requirements grows, 
there will be increased pressure on bank regulators to drop the 
leverage ratio requirements. For many large banks, satisfying the well-
capitalized leverage ratio is already the constraining capital 
requirement, rather than meeting risk-based capital ratios.
    The bank supervisors I have talked with are very worried at the 
prospect of dropping PCA requirements--they remember other times when 
banks' predictions about the future did not come true. They also point 
to their experience that well-capitalized banks are profitable banks, 
can enjoy lower costs of funding, and more easily weather economic 
downturns.
    I am concerned that without direction from supervisors, capital 
requirements could differ widely according to the parameter estimation 
methods used by banks, and depending on banks' own data sources. It is 
essential that the schedule for implementation allows enough time for 
supervisors to work with bank models, to understand different parameter 
estimation techniques, and to gauge sufficiency of data. Supervisors 
will then be able to develop necessary technical guidelines for the 
estimation process and to set the restrictions and constraints 
necessary to ensure adequate required capital. If this time is not 
allowed, there is a real danger that the estimation techniques ``most 
large banks choose'' will become the de facto ``best practices.''
    Allowing this supervisory review period will also ensure that the 
necessary examination procedures and guidance will be developed, both 
for Basel II and Amended Basel I. We need time to understand and assess 
these proposals, and once they are accepted, we need time to develop 
examination materials, to provide necessary training for examiners, 
particularly in the supervision of Basel II banks, and to provide 
support for bankers.
    It can take several years for a bank to develop the systems 
necessary for adoption of Basel II. Some of the largest banks have 
already begun this process, in order to be able to adopt Basel II at 
its effective date. I am concerned that maintaining the current 
timetable will intensify pressure to keep the Basel II proposal 
``open'' enough so that banks that have begun implementation projects 
will not have to make radical changes. This could make it very 
difficult to institute material changes in the future, when banks have 
committed even more sizeable resources to their Basel II systems. We do 
not know enough now about the consequences of Basel II to go ahead, in 
an attempt to justify the expenditures a few banks have already made.

Impact of Changes in Capital Requirements across U.S. Banking System
    Both bankers and supervisors are concerned about the impact of 
Basel II on the U.S. banking system. As pointed out in a letter sent by 
the Conference of State Bank Supervisors to the Federal Agencies in 
September of this year,

        Implementing the risk-based capital requirements depicted in 
        the recent studies could have profound competitive implications 
        and significantly harm the banking industry in general and non-
        Basel II banks in particular. As proposed, Basel II creates 
        significant differences between capital requirements of banks 
        that adopt Basel II and those that do not. The current approach 
        reduces the capital large institutions hold for mortgages and 
        small business loans, among other assets. In a very practical 
        sense, the reduced capital requirements would provide a pricing 
        advantage for the larger institutions. It will be difficult for 
        smaller banks to compete for mortgages and small business loans 
        and certainly difficult for these institutions to hold such 
        assets in their portfolio. In a competitive economy, eventually 
        market forces will likely drive these assets from smaller banks 
        toward the Basel II adopting banks, requiring nonadopting 
        banks, the vast majority of which are small community banks, to 
        move to higher-risk areas of banking.

        In addition, with substantially lower capital requirements, 
        larger institutions could acquire community and mid-tier banks 
        without much cost involved by immediately lowering the acquired 
        bank's required capital to a level that is allowed by Basel II 
        banks. The lower capital requirements and the magic of the 
        current Basel II mathematics promote the incentive for 
        consolidation within the banking industry.

    CSBS strongly urged the Federal banking agencies ``to conduct 
further analysis of potential capital changes that would ensue from 
adopting the current Basel II proposal.''
    I am afraid that the publicly available analysis does not 
adequately answer these concerns. The Federal Reserve has posted on its 
website several ``White Papers,'' covering some Basel II portfolios and 
some of the competitive issues raised by the original ``bifurcated'' 
regime proposed by the agencies. However, these papers are based on 
Basel II circa 2003, and both the Basel Committee and the Federal 
agencies have made changes to their proposals since then. The new 
Amended Basel I proposal, of course, is not considered at all in this 
research. The ``White Papers'' suggest that the impact on non-Basel II 
banks may be minimal, but these papers are not definitive, and other 
authors have disagreed with their findings.
    We need to have a much better understanding of the consequences of 
Basel II before it is implemented. We should take the time now--both 
Federal and State banking regulators--to fully test the impact of Basel 
II and Amended Basel I proposals. In this way, we can work to safeguard 
the soundness and profitability of the banking system and ensure that 
U.S. borrowers will continue to have the access to capital that a 
strong U.S. banking system affords them.
    I hope that these remarks are helpful to the Committee and would be 
pleased to answer any questions that you have.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY 
                    FROM SUSAN SCHMIDT BIES

Q.1.a. Basel II would impose new demands on bank regulators. It 
would require bank regulators to not only approve banks' 
internal assessments of their risks, but also to make judgments 
on whether banks are holding enough capital in light of all the 
risks banks face. This means bank regulators are going to need 
personnel who are well trained in risk analysis.
    How many additional personnel does your agency expect it 
will need to hire in order to implement Basel II? What type of 
expertise will your agency need to obtain? Do you foresee any 
problems in recruiting?

A.1.a. The Federal Reserve has been preparing for the 
implementation of Basel II for some time. Preparation includes 
planning for reallocations of existing staff, hiring of new 
staff, and planned training enhancements, all started as far 
back as 2001. It is difficult to quantify exactly the number of 
personnel associated with Basel II as our planning is tightly 
integrated with broader continuing initiatives to expand and 
augment System expertise in areas such as risk management and 
quantitative analysis. That is, we are not hiring supervisory 
staff only for Basel II implementation purposes. In fact, even 
without the movement to an enhanced risk-based capital 
framework, supervisors have, for some time now, been addressing 
the implications for Federal Reserve staffing and specialized 
training of quantitative risk management models and techniques 
as their use at financial institutions has grown around credit, 
operational and other risks.
    With regard to expertise, staffs at Reserve Banks are 
working with staff of the Board of Governors to support Basel 
II and risk-related policy requirements. Quantitative risk 
units have been established within the Federal Reserve System 
to serve the System's need for specialized expertise in this 
critical area. Specific expertise includes staff with risk 
management, quantitative analysis, and modeling skills, and 
technically trained industry experts with market and 
operational risk, corporate credit, and retail credit risk 
experience.
    In an effort to appropriately prepare Federal Reserve 
System staff for the implementation of the Basel II framework, 
a number of training programs are already in place to ensure 
that supervisors will be ready to meet the challenges posed by 
U.S. implementation of the framework at the local level. Also 
important are coordination efforts across Federal Reserve 
districts to maximize the efficient deployment of experts and 
cooperative interagency training efforts to share expertise 
among banking supervisors.
    Recruiting in a competitive environment will continue to be 
a challenge. This would have been the case even without Basel 
II as use of quantitative models at banking organizations 
continually expands. The Federal Reserve is prepared to use all 
tools in place to ensure that qualified staff with the 
requisite skills are recruited and retained and that there is 
sufficient investment in training for existing staff, as 
further elaborated in responses 1b and 1c.

Q.1.b. Will your agencies be able to successfully compete 
against banks in the recruitment of personnel? Do you have any 
concerns that banks will simply be able to hire the best 
Ph.D.'s in risk modeling and outgun their regulators?

A.1.b. The need to ensure successful recruiting and retention 
of specialized staff--not only for overall supervision but also 
for Basel II as well--has consistently been a focus for the 
Federal Reserve. The quality and effectiveness of our 
supervisory efforts depend most importantly on the quality and 
knowledge of our staff. Over the years, we have been successful 
in recruiting and retaining the staff necessary to carry out 
our responsibilities in an effective manner, despite growing 
demand and competitive salary pressures for our well-regarded 
and highly skilled examiners and staff. Basel II, of course, 
has been a key focus for the last 24-36 months. As the private 
sector has come to recognize the value of these skills, the 
demand for specialists with risk-management skills has 
increased the total compensation packages that our staff can 
earn in the private sector. The ``value proposition'' of 
working at the Nation's central bank in a policy and public 
service role, in addition to factors such as competitive 
benefits packages and work/life balance options are partial 
offsets to external market pressures. Recruiting for 
specialized expertise, especially quantitative modeling and 
analysis, is necessarily expensive, and pushes the limits of 
existing pay structures. Successful recruits will typically 
command the upper end of the pay scale in some cases. The 
research staffs at the Federal Reserve Banks and the Board 
provide a significant pool of internal expertise in areas such 
as risk modeling and quantitative analysis. As in times past, 
we will use research staff with quantitative expertise to 
assist risk specialists and examiners on the supervision staff, 
as needed.

Q.1.c. How much in additional annual costs do you expect to 
incur in implementing Basel II? Other than personnel costs, 
what other costs will your agency incur in implementing Basel 
II? Are there any large one-time costs?

A.1.c. Over a 5-10-year timeframe, the Federal Reserve will 
make considerable investments related to Basel II, including 
the cost of course development and training hours for 
examiners. There will also be some costs associated with 
collection and analysis of new data related to the Basel II 
implementation.
    The total training requirements will depend, in part, on 
how many banks opt-in to Basel II. As noted in our response to 
1a, these efforts have been in progress for several years and 
are integrated tightly with broader initiatives to ensure our 
supervisors are well-trained to meet the complexities and rapid 
change in supervised organizations. In addition, both Reserve 
Banks and Board supervision functions are continually 
reprioritizing resources to address our most pressing concerns 
including the effective supervision of the most complex 
organizations. As a result, we have reallocated staff 
development funds to augment our training programs around risk-
management techniques including those related to an enhanced 
risk-based capital framework. Two courses have been developed 
for examiners and quantification experts at the Reserve Banks 
related to credit risk measurement and quantification for 
corporate and retail activities. A third course, developed 
jointly with the Office of the Comptroller of the Currency, the 
Federal Deposit Insurance Corporation, and the Office of Thrift 
Supervision, focuses on operational risk and provides a 
description of the range of advance measurement approach (AMA) 
practices, including specific examples of how banks might 
implement their AMA processes. An agreement with the BIS 
Financial Stability Institute for online learning provides a 
wide variety of tutorials on subjects related to capital 
adequacy and will require a modest outlay of funds over the 
next 2 years. We do not currently anticipate any large one-time 
expenses related to Basel II. However, we are finding it 
necessary to use enhanced compensation and benefits to attract 
and retain staff with critical skills in quantitative risk-
management techniques and other important supervisory skills 
areas.

Q.2.a. In his testimony, Dr. Tarullo posed several questions 
that he believes need to be answered by U.S. banking agencies 
before implementation of Basel II begins. Please provide 
answers to his questions with respect to your agency, which are 
as follows:
    ``Do the agencies believe that, in general, minimum capital 
levels are too high and, if so, what is the basis for that 
belief ?"

A.2.a. For most banking organizations, minimum regulatory 
capital levels today are adequate. However, for our largest, 
most complex banking organizations, Basel I-based capital rules 
have become increasingly inadequate and do not provide 
supervisors with a conceptually sound framework for assessing 
overall capital adequacy in relation to risks, including which 
institutions are outliers, and how capital adequacy may evolve 
over time. That said, we do know that, for some individual 
banking organizations minimum regulatory capital levels 
required to be held against some of the assets they hold, and 
the inherent risks in those assets and operations, may be too 
high. Similarly, there are also some banking organizations 
whose assets and operations are riskier than average and thus, 
for particular assets, their minimum capital requirements may 
be too low. The current framework does not distinguish between 
those organizations that are taking on greater risk versus 
those that are not. That is one of the limitations of Basel I 
and why a more risk-sensitive approach is needed for our 
largest, most complex banking organizations.
    One should remember that simplifying assumptions are built 
into minimum regulatory capital requirements, such as Basel I, 
so that they can apply to a wide range of institutions. 
Accordingly, they cannot get to a level of granularity that 
will provide a tight linkage between risks that are being taken 
and the amount of capital needed for every single banking 
organization. For the largest, most complex banks, Basel II 
attempts to provide more granularity and risk sensitivity, but 
it still only looks explicitly at three types of risk in Pillar 
l--credit, market, and operational. As such, there are still 
risks that are not explicitly accounted for in the Basel II 
risk-based minimum capital numbers, such as liquidity, 
concentration, interest rate, and legal-compliance risks. That 
is why Basel II has a component of capital evaluation in Pillar 
2.
    Minimum regulatory capital requirements simply cannot 
explicitly reflect all the risks that every banking institution 
undertakes. To do so would, indeed, be excessively burdensome 
and not cost effective. Minimum regulatory capital measures 
provide floors below which capital should not fall. The 
agencies have instead relied significantly on the supervisory 
process to supplement minimum regulatory capital requirements 
and ensure that a banking organization holds an amount of total 
capital that is adequate in relation to all the risks faced by 
the organization. Pillar 2 of Basel II reinforces the 
importance of a bank's internal and supervisory assessments of 
its overall capital adequacy. The agencies also have relied, 
and will continue to rely, on a minimum leverage ratio 
requirement to supplement the risk-based capital requirements 
for both Basel I and Basel II.
    Successful internal capital adequacy processes (economic 
capital) at the largest banking organizations emphasize the 
need to identify and measure all relevant risks. Most 
institutions maintain a ``cushion'' above internally generated 
capital measures for various reasons. The actual total capital 
a bank holds above the regulatory minimum reflects bank 
management's assessment of risks the institution faces, and the 
related amount of capital the institution needs to cover all of 
its unexpected losses. Sometimes investors, counterparties, and 
customers demand a stronger credit rating at the bank than that 
implied by the minimum regulatory capital requirements. Many 
banks also want to remain prepared to promptly pursue mergers 
and new business expansion opportunities as they arise, which 
requires maintaining capital above the regulatory minimum. 
Banks may also wish to hold additional capital in anticipation 
of reduced ability to raise it in future periods. Such 
justifications for holding capital above the regulatory minimum 
are entirely appropriate, indeed necessary for determining the 
appropriate level of total, rather than minimum regulatory, 
capital for an individual institution. In the supervisory 
process, we check to see that all minimum regulatory capital 
requirements are met, but we also analyze a banking 
organization's total capital and its rationale and plans for 
maintaining that capital in order to assess whether its capital 
is adequate given its risk profile.

Q.2.b. ``Have the agencies been able to predict with reasonable 
precision the levels of capital that the A-IRB approach will 
require of large banks, and then to confirm their prediction 
through studies that are well-conceived and executed?''

A.2.b. The Basel II implementation plan for the United States 
has incorporated from the outset an ongoing process for 
evaluating both the quantitative impact of Basel II on banks' 
minimum risk-based capital requirements and the quality of 
banks' systems for calculating Basel II risk parameters. One 
element of this process has been several quantitative impact 
studies (QIS) conducted over the past several years. The most 
recent QIS exercise, QIS-4, provided valuable insights into 
banks' minimum regulatory capital relative to their risk 
profiles, the varying methodologies used to measure risk, and 
where banks' risk-measurement and -management capabilities are 
stronger or weaker relative to their peers.
    Consistent with the agencies' expectations, QIS-4 provided 
somewhat limited insights into what would be the minimum 
required capital under Basel II when fully implemented. Like 
its predecessors, QIS-4 was conducted on a ``best-efforts'' 
basis without close supervisory oversight, and it reflects only 
a point-in-time look at banks' portfolios and risk-measurement 
and -management systems (in this case, as of the second or 
third quarter of 2004). An important finding was that banks' 
systems for estimating Basel II risk parameters were only 
partially developed at the time of QIS-4 and would not meet 
supervisors' expectations for reliability. As a result, the 
QIS-4 results may not represent accurately the minimum capital 
charges that would be generated by Basel II when banks' systems 
are fully compliant with their risk measurement and management 
standards. Indeed, QIS-4 showed that while banks have been 
making steady progress in improving the quality of these 
systems, no institution would have been qualified to implement 
Basel II at the time of QIS-4.
    Uncertainty surrounding the precise quantitative impact of 
Basel II has been incorporated into the agencies' 
implementation plan for the United States as outlined in our 
September 30, 2005, press release. The plan recognizes 
explicitly that the agencies cannot be certain about the 
quantitative impact of Basel II until banks have fully 
implemented the systems needed to support the framework. Yet, 
banks cannot build up these systems until the agencies have 
released a notice of proposed rulemaking (NPR) and accompanying 
examination guidance setting forth our qualification standards. 
There may also be additional changes in the final rule that 
banks will need to take into account. More precise estimates of 
the quantitative impact of Basel II should become available 
during the ``parallel run'' period (beginning January 2008) and 
the transition years (from 2009 to 2011). The agencies will 
periodically review and analyze data collected from the Basel 
II banks during these periods, as we continue to evaluate the 
quantitative impact of Basel II. The agencies will use this 
information to determine whether any modifications to the Basel 
II framework, particularly to Pillar 1, are needed, for 
example, to preclude any unwarranted decline in banks' minimum 
risk-based capital requirements. To ensure adequate time to 
make such adjustments, over the 3 years following the parallel 
run, Basel II would be phased-in by constraining each bank's 
consolidated risk-based capital charge to be at least 95 
percent, 90 percent, and 85 percent of Basel 1 levels in 2009, 
2010, and 2011, respectively. In addition to these transitional 
safeguards, the current prompt corrective action (PCA) 
framework and minimum leverage ratio requirement will remain in 
place. Taken together, we believe these measures will ensure 
that banks maintain prudent capital levels throughout the 
transition period and beyond.

Q.2.c. ``Have the agencies done scenario planning to anticipate 
the effects, unintended and otherwise, of Basel II upon the 
financial system as a whole? For example, are the significant 
portions of certain kinds of assets likely to migrate out of 
the banks into the unregulated sector? If so, might new risks 
of financial disruption be created?''

A.2.c. It is important to note that one of the motivating 
factors for pursuing capital reform is to reduce existing 
financial market distortions that are the result of banks' 
efforts to arbitrage Basel 
I-based rules, such as by securitizing high-quality assets and 
retaining lower-quality, yet higher-yielding, assets. That 
said, the Federal Reserve takes the potential effects produced 
by Basel II very seriously. Throughout the Basel II process, we 
have remained vigilant about the impact of our decisions. This 
includes conducting analyses, such as our series of white 
papers about the effects of Basel II on certain aspects of the 
U.S. banking system. We have also remained very attentive 
throughout the Basel II process to comments from the industry, 
the Congress, and other interested parties about the potential 
effects of Basel II on the financial system. When information 
from any of these sources or evidence from risk models in use 
identified modifications that should be made, we have pushed 
for adjustments to strengthen the proposed capital requirements 
of Basel II.
    To the extent that Basel II better reflects risk-taking by 
banks, minimum regulatory capital should be more consistent 
with the view toward risk and capital that rating agencies and 
investors have been using both for banks and their competitors. 
In general, it is our view that there will not be disruptions 
to the financial system as a result of Basel II, nor should 
there be a sizeable migration of assets outside the banking 
system to non-bank entities. But, as with any change in capital 
rules, bankers will evaluate options and optimize their use of 
capital, so some adjustments are likely. For example, the 
introduction of PCA in the early 1990's encouraged even the 
largest banks to hold more additional excess capital so they 
would qualify to be deemed ``well-capitalized''.
    In most cases, our analysis suggests that it is usually not 
minimum regulatory capital levels that significantly affect 
where assets are held, but rather the capital allocations that 
banks (and others) make internally within their organization, 
so-called economic capital. Moreover, most banks, and 
especially the smaller ones, hold capital far in excess of 
regulatory minimums for various reasons (as outlined in 
question 2a, above). Thus, in normal circumstances, changes in 
a bank's own minimum regulatory capital requirements for 
particular assets generally would not have a sizeable effect on 
the level of actual capital the bank chooses to hold and would 
not necessarily have sizeable affects on internal capital 
allocations. In short, we do not expect Basel II to 
significantly change the market realities among banks, or 
between banks and non-bank financial entities.
    Naturally, if we see evidence that distortions might arise 
from Basel II, we will seek to review and analyze the specific 
situation and make adjustments to the U.S. capital proposals 
accordingly. As you know, the agencies have embedded in their 
plans for United States implementation of Basel II a number of 
safeguards, given some of the uncertainty that still remains 
about Basel II's ultimate effects. These include the parallel 
run period, 3 years of transitional floors, and additional 
rulemakings. And, as noted elsewhere, we will perform periodic 
reviews and analysis of the quantitative impact of Basel II on 
individual banks and in the aggregate.

Q.2.d. ``What do the agencies regard as the effective capacity 
of the specialized examiner teams that will be overseeing the 
use of bank models under A-IRB? How will the agencies determine 
whether other countries are successfully monitoring bank 
capital levels under the A-IRB approach?''

A.2.d. As noted in question 1 above, the Federal Reserve has 
been preparing for some time to prepare for policy and 
implementation requirements associated with Basel II. We 
already have considerable expertise and experience related to 
evaluation of quantitative risk models in the supervision of 
our largest and most complex banking organizations. As you 
know, U.S. supervisors are still developing their Basel II 
proposals, associated supervisory guidance, and proposals for 
Basel II data collection. These taken together will provide a 
lot of detail to both the examination staff and the banking 
organizations using Basel II, and will support consistency 
across U.S. supervisors and clarify our standards to other 
countries.
    To address concerns about inconsistent application of the 
Basel II framework across countries, the Basel Committee 
several years ago established the Accord Implementation Group 
(AIG), made up of senior supervisors from each Basel member 
country. The AlG gathers regularly to share best practices and 
develop ways to foster consistent application of Basel II 
across national jurisdictions. As discussions about 
implementation become more detailed and more focused on 
specific banking groups, they move out of the AIG and evolve 
into bilateral supervisory relationships dealing with practical 
details. The AIG has also published a substantial amount of 
information so that other supervisors and bankers can benefit 
fTom some of the AIG's discussions and have a better sense of 
the expectations of AIG members. No doubt there will be some 
differences in application of Basel II across banking systems 
with different institutional and supervisory structures. All 
AIG members, and certainly the Federal Reserve, would remain 
alert to this issue and work to minimize differences in 
application. However, it is helpful to remember that issues 
relating to cross-border supervision already exist today, and 
U.S. supervisors have extensive experience in addressing such 
issues. With Basel II, as is currently the case, host 
supervisors will still examine the legal entities in their 
country. Accordingly, U.S. bank subsidiaries of foreign banks 
would be operating under United States rules and foreign bank 
subsidiaries of U.S. banks would be operating under foreign 
host-country rules. As part of our home-host communication, we 
will keep foreign supervisors informed about how operations 
outside their jurisdiction affect the entities they supervise, 
and do this with a minimum of burden on the consolidated 
organization. We expect the reverse to be true as well. And, of 
course, we continue to maintain an ongoing dialogue with 
institutions for which we are the home or the host supervisor. 
The sooner that institutions raise specific issues of concern 
with us, the quicker we will be able to work on solutions and 
the smoother the transition is going to be.

Q.2.e. ``Have the banking agencies consulted with institutional 
investors, rating agencies, independent analysts, and other 
market actors concerning the amount of information about their 
credit modeling that A-IRB banks will be required to disclose? 
[If so, what were the views of these market actors as to the 
adequacy of the contemplated disclosure requirements?]''

A.2.e. The Pillar 3 disclosures were issued for public comment, 
both formally and informally, on several occasions. In 
addition, representatives of the agencies consulted with market 
participants in developing the disclosures. In general, market 
participants, such as debt and equity analysts, support 
enhanced public disclosures of risk information and capital 
adequacy by banking organizations. The version of Pillar 3 
included in the June 2004 text from the Basel Committee 
balances the desire for additional disclosures by market 
participants and the reporting burden associated with such 
disclosures. This version leverages off of the information 
institutions will need in order to implement Basel II and is 
substantially streamlined from earlier Pillar 3 proposals.

Q.2.f. ``Do the banking agencies continue active study of 
alternative approaches to capital regulation, such as the 
varieties of proposals based on market discipline or on so-
called precommitment?''

A.2.f. The agencies, on an ongoing basis, consider ways to 
improve the existing risk-based and leverage capital regimes. 
Over the past 15 years or so, the agencies have adopted over 28 
modifications to the existing risk-based and leverage capital 
regime. In addition to this ongoing incremental maintenance and 
refinement, the Basel II process is one example of developing 
an entirely new approach to capital regulation--part of this 
process has included considering alternative approaches and 
reaching consensus on the approaches determined to be most 
appropriate. Further, the Federal Reserve has ongoing dialogue 
with other agencies and standard setters such as the SEC and 
FASB to consider ways to enhance or refine our regulatory 
approaches.
    With regard to market discipline, the Federal Reserve Board 
and Treasury submitted a report to Congress on ``The 
Feasibility and Desirability of Mandatory Subordinated Debt'' 
in December 2000. The link to the report is: http://
www.Federalreserve.gov/boarddocs/rptcongress/debt/
subord_debt_2000. pdf.
    In that report, we noted that the Board will continue, and 
explore opportunities to enhance, its use of data from 
subordinated debt, equity, and other markets to evaluate the 
current and expected future condition of large depository 
organizations. With respect to subordinated debt, the Board 
will continue, as part of the supervisory process, to monitor 
both yields and issuance patterns of individual institutions.
    The Federal Reserve System continues to study market 
discipline and the use of market data and has an ongoing 
program of regularly reviewing market data, including 
subordinated debt spreads, credit default swap premiums, and 
stock price data, as part of our off-site surveillance program.
    With regard to ``precommitment''-based proposals, the 
agencies did evaluate proposals incorporating this concept 
prior to the adoption of the Market Risk Amendment. However, 
the agencies decided not to incorporate such proposals given 
various shortcomings, including that supervisors would be 
required to impose higher capital requirements on firms after 
the fact, rather than ensuring that there is adequate capital 
on an ex-ante basis.

Q.3. Although Basel I-A aims to reduce any competitive 
advantage Basel II may confer on large banks, have you 
conducted any analysis to determine whether Basel I-A itself 
creates any competitive issues within the subset of banks that 
are intended to be covered by it? If not, do you intend to do 
so?

A.3. In the Basel I ANPR, the agencies articulate five broad 
principles to guide the developing revisions. These principles 
are to (1) promote a safe and sound banking system, (2) 
maintain a balance between risk-sensitivity and operational 
feasibility, (3) avoid undue regulatory burden, (4) create 
appropriate incentives for banking organizations, and (5) 
mitigate material distortions in the amount of minimum risk-
based capital requirements for large and small institutions. As 
you know, the Basel I changes are still in the developmental 
stage and as work progresses, competitive equity issues will 
continue to be a primary area of focus--not only between the 
Basel I and Basel II frameworks, but also within each of those 
frameworks. Staffs have done some preliminary analysis using 
existing Call Report data to understand the potential impacts 
of various risk-weight changes and combinations of risk-weight 
changes. As the proposed Basel I modifications continue to 
evolve, additional analyses will be performed to ensure that 
the agencies understand the possible effects of each 
modification that the agencies consider proposing.

Q.4. What consideration has been given to the fact that there 
are huge differences between the 7,000 or so banks that will 
participate in the Basel I-A framework?

A.4. The agencies' existing risk-based capital rules generally 
apply to banks, thrifts, and bank holding companies of all 
types and sizes. As we continue developing modifications to the 
current rules, with the guiding principles set forth in the 
response to question 3 in mind, we will endeavor to develop a 
package of revisions that enhances risk sensitivity without 
being unnecessarily burdensome. The current regime is a broad-
brush approach that results in a modestly risk-sensitive 
framework that can be used by a variety of institutions. We 
expect that a modified Basel I-based set of rules also will be 
applicable to a wide range of institutions with different risk 
profiles and management and measurement approaches. As part of 
the Basel I ANPR issued last year, the agencies specifically 
sought comment on whether the proposed modifications should be 
applied to all non-Basel II banks or whether some or all non-
Basel II banks should be given a choice of applying the 
existing risk-based capital rules or the risk-based capital 
rules that emerge from the process to amend Basel I.

Q.5. In Dr. Kaufman's testimony, he stated that there is 
``substantial empirical evidence of a negative relationship 
between leverage ratios and bank solvency,'' but ``no such 
evidence between risk-based capital ratios and bank solvency.'' 
Do you agree with Dr. Kaufman? If so, does this conclusion 
undermine the Basel II framework?

A.5. The Federal Reserve does not believe this is an accurate 
application of extant research as it relates to Basel II. 
Research employing the Basel I capital ratios is not at all 
relevant for evaluating fundamentally different risk-based 
capital ratios that are designed to be significantly more risk-
sensitive than Basel I, such as those under Basel II when fully 
implemented. In this regard, the Basel II framework should 
provide better insights into banks' overall capital adequacy on 
an aggregate and individual basis, and how this evolves over 
time, thus reinforcing the goal of the PCA regime to intervene 
as early as possible at problem institutions. Accurate data for 
assessing the efficacy of the Basel II capital ratios, however, 
will not be available until banks have fully implemented the 
systems needed to support the Basel II framework and have 
access to more detailed information about supervisory 
expectations for various aspects of Basel II that will be 
included in the NPR and associated supervisory guidance.
    Fortunately, minimum capital ratios are only one 
supervisory tool the banking agencies use to monitor and assess 
the overall condition of U.S. banking organizations. We have 
tailored risk-focused examination practices that will continue 
to be applied to ensure we have a solid and accurate 
understanding of each institution subject to the agencies' 
jurisdiction. In both Basel I and Basel II, supervisors are 
able to intervene to require stronger capital above the 
minimums when internal controls, weak earnings performance, or 
loss exposures are a concern.

Q.6. Have you undertaken any analysis of the initial start-up 
costs and annual compliance costs that Basel II will impose on 
banks?

A.6. Most of the information we have to date is anecdotal. On-
site supervisory examination teams have ongoing dialogue with 
institutions that are expected to be moving to the Basel II 
advanced approaches to get a sense of the cost implications. 
That information seems to change periodically. Further, some 
institutions have reported to us that the delay in issuing the 
NPR and modifications to the framework will increase their 
costs.
    In addition, through the QIS-4 supervisory questionnaire 
process, some institutions answered questions about compliance 
costs related specifically to ongoing compliance as well as 
start-up and recurring costs but the responses that were 
received were not comprehensive or easily comparable across 
institutions and therefore were not included in the QIS-4 
results.
    Finally, much of the infrastructure development needed for 
Basel II is consistent with supervisory expectations for 
advanced risk measurement and management in general, so some 
element of cost, while consistent with, is not necessarily 
exclusive to Basel II. As a continuing part of the Basel II 
process, the agencies will seek to obtain more complete and 
reliable information.

Q.7. To what degree will the significant costs necessary to 
comply with Basel II act as a barrier to entry that prevent 
banks from growing and becoming a bank large enough to qualify 
to use Basel II? In effect, will Basel II cement the market 
positions of the largest banks? If not, why?

A.7. When evaluating the costs to U.S. banks of adopting Basel 
II, it is important to note that all large or complex banks 
need to have in place appropriate systems for measuring and 
managing their risks. Banks that are not large and do not have 
complex products or portfolios do not need complex measures of 
risk-taking either for sound risk management purposes or for 
minimum regulatory capital requirements. Much of the cost of 
adopting Basel II is associated with developing and 
implementing such systems for internal management purposes, and 
so we would expect such costs to be incurred by a large bank 
even in the absence of Basel II. Indeed, the risk-management 
approaches underlying Basel II, including economic capital 
precepts, reflect the general direction that large, well-
managed banks have been moving to since the mid-1990's.
    The issue is the same for a non-core (that is, opt-in) 
bank. As an existing supervisory issue, regardless of whether 
there is a Basel II, we would expect a large and growing bank, 
especially one nearing the size criteria that is envisioned in 
the Basel II context, to have risk measurement and management 
systems appropriate for their size and risks, including 
internal economic capital methodologies for managing their 
businesses. What Basel II does is ask them to make sure that, 
as they build more robust risk management systems, those 
systems can also generate various risk parameters to permit 
calculation of risk-based capital using the supervisory 
formulas. So as a bank continues to grow toward the Basel II 
criteria, it should be both improving its risk management and 
preparing to have its systems generate required Basel II 
criteria. Improving risk management systems as a bank grows in 
size or complexity should be considered as a cost of doing 
business.
    There may also be concerns that Basel II will reduce the 
capital requirements for some banks and not others. That is one 
of the reasons why the banking agencies have proposed to amend 
Basel I so that competitive effects can be minimized. As noted 
above, the Federal Reserve recognized that competitive effects 
were possible and undertook several studies designed to assess 
the possibility that adoption of Basel II would provide 
adopters with a substantial competitive advantage over non-
adopters. While these studies point to a few areas in which 
some competitive effects may occur, their overall findings 
strongly suggest that competitive effects of Basel II are 
likely to be modest. One study examined whether a reduction in 
regulatory capital requirements resulting from adoption of 
Basel II would prompt large adopting banks to acquire smaller, 
non-adopting banking organizations. A second study addressed 
whether changes in regulatory capital requirements brought 
about by Basel II would provide large adopting banks with a 
competitive advantage in small business lending; the third and 
fourth studies addressed similar questions as they apply to 
mortgage lending and credit card lending, respectively. A fifth 
study addressed the likely effect of explicit operational risk 
charges on processing banks that adopt Basel II. And even 
though anticipated effects are likely to be modest, because 
these studies, public comments, and other factors pointed to 
some unintended competitive consequences from the 
implementation of Basel II, the U.S. banking agencies are 
developing a revised Basel I that is partially aimed at 
addressing such concerns.

Q.8. Please explain the type of information that banks will be 
required to disclose under Pillar 3 with respect to how banks 
calculate their capital requirements? Will banks be required to 
disclose proprietary capital requirement models?

A.8. Consistent with the Pillar 3 disclosure requirements in 
the Basel Committee 2004 mid-year text, the agencies will be 
proposing, at about the same time as the NPR, to collect 
information, both qualitative and quantitative, related to 
scope of application (that is, what entities within an 
organization are using the Basel II-based capital rules), an 
institution's capital structure, capital requirements as 
calculated under the rules, as well as disclosures related to 
specific risk areas including: Certain credit risk-related 
exposures, credit risk mitigation, securitization, market risk, 
operational risk, equities and interest rate risk. Under the 
Pillar 3 requirements, banks will not be required to disclose 
propriety information related to their capital models.

Q.9. If Basel II is implemented, do you favor at any point in 
the future reducing the leverage ratio for well-capitalized and 
adequately capitalized banks or reducing the statutory capital 
thresholds for prompt corrective actions?

A.9. The Federal Reserve is not in favor of any attempt to 
reduce or eliminate the leverage ratio, nor to reduce or 
eliminate statutory thresholds for PCA. These existing 
requirements would provide additional protection against 
possibly unfavorable outcomes in Basel II implementation. From 
a minimum regulatory capital perspective, not all risks have 
been explicitly incorporated into the Basel II-based framework 
in terms of a specific capital charge. To be clear, we believe 
that the leverage ratio and PCA rules should remain in place 
for banks operating under both Basel I and Basel II rules.
    The Federal Reserve also would note that all of the banking 
agencies would need to concur before bank leverage requirements 
and PCA thresholds could be eliminated. Moreover, since 
Congress has mandated some aspects of these requirements for 
banks, changing them would require an act of Congress.

Q.10. In his testimony, Mr. Isaac points out that compared to 
European banks, ``large U.S. banks are much better capitalized 
and far more profitable in terms of their operating margins.'' 
Do you agree or disagree with Mr. Isaac's observation, and what 
is your rationale for your position?

A.10. The strength and sustained earnings power of the U.S. 
banking industry over the past several years have indeed been 
remarkable. U.S. banks have regularly delivered record profits 
and higher shareholders' equity. In this setting, most 
comparisons of U.S. banking organizations with many foreign 
banks will favor the U.S. institutions. The chart below reports 
aggregate capital measures for the seven U.S. bank holding 
companies and 28 private-sector European banks with assets 
greater than $200 billion, based on public disclosures and 
shown on a merger-adjusted basis. Crude equity-to-assets ratios 
(shown as bars) were significantly higher for the U.S. banking 
organizations. Gauged by the total risk-based capital ratio, 
however, capital levels at the largest American and European 
banks were roughly comparable over the last decade. During the 
10 years ending in 2004, U.S. banks reported a total risk-based 
capital ratio of 11.63 percent on average, only 29 basis points 
above that for European banks. Although in most of these years 
the average ratio for U.S. banks was higher, in others (1997 to 
1999) the average ratio for European banks exceeded that for 
U.S. banks. Both sets of results contrast sharply with data for 
1994, which show sharply higher capital ratios for U.S. banks 
that reflected buttressing at many U.S. banks against still-
significant asset quality problems and a buildup of capital 
ratios at European banks during the early years of the Basel I 
regime.




    Although there are many differences between the balance 
sheets and risk profiles of U.S. and European banking 
organizations, the difference that seems to be most important 
to this comparison of capital ratios is that the European banks 
tend to have relatively higher concentrations in government 
bonds and other assets that receive low risk weights under the 
current Basel standards. The risk-based capital ratios take 
account of this difference in risk profiles--albeit crudely--
while the equity-to-assets ratios do not.
    All 35 of the large institutions in the data above, and 
indeed nearly all banking organization in these countries, hold 
capital well in excess of their current regulatory minimum 
requirements and are judged to be adequately capitalized--or 
better--by their regulators. As such, the differences in 
capital levels are best understood as the result of choices 
made by the organizations' management rather than a competitive 
advantage or disadvantage. Minimum capital requirements are 
just one of many factors bank managements consider in 
developing their capital policies. Banks may choose the size of 
their capital ``cushions'' with many objectives in mind, 
including positioning themselves as desirable counterparties, 
managing funding costs, optimizing their risk profile, and 
taking advantage of potential growth opportunities. Market 
discipline plays an especially significant role for these 35 
institutions because all are active in global financial markets 
and are thus subject to the scrutiny of their counterparties 
around the world. Supervisors review the capital cushions and 
their rationale as part of the larger assessment of capital 
adequacy, but the size of the cushions is based on managements' 
own assessments and judgments.
    Turning to profitability, the chart below displays 
aggregate return on average assets (ROA, a reasonable proxy for 
overall operating margins) for the same group of large U.S. and 
European banking organizations, showing that on this basis U.S. 
banks indeed have generated consistently higher profit margins. 
Market participants and supervisors generally prefer to measure 
profitability as return on equity, that is, as the ultimate 
return to shareholders. On this basis, a differential in 
profitability is still evident although less pronounced and not 
present in every year.
    Since 1994, return on equity averaged roughly 16 percent 
for U.S. banks versus 12 percent for European banks.




Q.11. Do you believe that U.S. banks are operating at a 
significant disadvantage vis-a-vis foreign banks due to the 
higher capital requirements imposed on U.S. banks? If you do, 
please explain in detail and quantify the competitive effects 
on U.S. banks, including giving your assessment of how low U.S. 
capital requirements would need to go in order to level the 
playing field with large foreign banks.

A.11. Minimum regulatory capital requirements imposed on 
internationally active U.S. and foreign banks have been 
substantively the same since the implementation of the 1988 
Basel Accord. The 1988 Accord was intended to bring global 
commonality to the 
assessment of capital adequacy and to promote stronger capital 
positions in banks globally. There exist some differences in 
implementation across local jurisdictions that arise in large 
part from differences in banking system structures, accounting 
practices, and capital instruments. Nonetheless, the risk-based 
capital ratios provide reasonably comparable indicators of 
capital adequacy.
    Such assessments and comparisons between U.S. and local 
jurisdiction requirements are performed routinely by the 
Federal Reserve as part of its responsibility to supervise 
State-chartered branches and agencies of foreign banks 
operating in the United States. Foreign banks intending to do 
business in the United States are expected to meet the same 
general standards, experience, and reputation as required for 
domestic institutions.
    As noted in the response to question 10, large banking 
organizations in the United States and Europe--and indeed 
nearly all banks in these countries--have operated at capital 
levels well in excess of these regulatory minimum standards for 
many years. The size of these capital cushions is chosen by 
these institutions' management after considering a number of 
factors, including the 
demands and expectations of the banks' counterparties and 
customers, and investors, the needs of the institutions' 
particular business strategies, the institutions' funding mix 
and costs, the overall risk posture of the institutions, and 
flexibility to accommodate future business growth or 
acquisitions. Supervisors review the capital cushions and their 
rationale as part of the larger assessment of capital adequacy, 
but the size of the cushions is based on managements' own 
assessments and judgments.
    Despite the convergence of capital standards and guidelines 
for meeting capital equivalency for foreign banks operating in 
the United States, there remains the perception that higher 
capital requirements are imposed on U.S. banks, placing 
domestic banks at a competitive disadvantage vis-a-vis foreign 
banks. Such perception may be based on the additional leverage 
requirement for U.S. banks based on the ratio of Tier 1 capital 
to total assets. These additional requirements support the 
safety, soundness and resilience of the U.S. banking system. 
Actual capital adequacy ratios remain well above all regulatory 
minimum levels, including Tier 1 leverage requirements and 
standards for being well-capitalized under PCA, at essentially 
all U.S. banks and all of the largest European institutions. As 
such, there is no indication that capital adequacy requirements 
have significant effects on the competitive balance between 
U.S. and foreign banks.

Q.12. If capital standards are reduced for the largest U.S. 
banks, do you believe that will place U.S. banks that do not 
implement Basel II at a competitive disadvantage vis-a-vis 
banks that do implement Basel II? If so, how do you suggest 
that competitive inequity be remedied?

A.12. The Basel I ANPR presented options to make minimum 
regulatory capital more reflective of risk. The regulators are 
proposing to recalibrate capital by portfolio type to reflect 
higher or lower risk exposures based on current information. A 
better alignment of capital to risk in Basel I would mitigate 
the potential differences between that framework and the more 
risk sensitive Basel II framework. As noted earlier, one of the 
objectives of the amended Basel I ANPR was to begin the process 
of making enhancements to the existing minimum risk-based 
capital rules for all banking institutions operating in the 
Unites States, in part, to mitigate competitive inequities that 
may arise between organizations using the Basel I-based rules 
and those using the Basel II-based rules. Overall, we believe 
that potential competitive inequities arising from the two sets 
of rules will be limited. As we go forward, we want to ensure 
that institutions not moving to Basel II have fair 
opportunities to pursue business initiatives and are not 
adversely affected. We will continue to work on these 
initiatives in tandem and will be seeking input from the 
industry, Congress, and others along the way, particularly 
related to the potential effects of both initiatives.

Q.13. Have you considered requiring the largest U.S. banks to 
implement Basel II-type models as part of their risk management 
programs without making Basel II a capital-regulation device? 
If you have considered and rejected such an approach, please 
explain why you rejected it.

A.13. We have considered whether we can just continue to 
encourage the improvement in risk modeling at banks and stop 
there, that is, not tie risk models to capital. While 
improvements in the methodology of risk models and the 
transparency of better risk modeling in business decisionmaking 
are very useful, it is our view that one cannot stop there. 
Banks that have similar models of risk can have very different 
inherent levels of risk. That is, each institution has to 
decide what level of risk it is willing to accept to run its 
business. Some organizations are willing to take on much 
greater levels of risk than others. Some lines of business and 
some products are inherently riskier than others, while some 
organizations may be more adverse to accept risk than others.
    For safety and soundness reasons, bank supervisors must be 
sure that a bank with greater exposure to riskier lines of 
business, products, and customers holds more capital than a 
bank that is more risk adverse and designs its business plan to 
minimize risk-taking. That is, just looking at risk models and 
not tying capital to the measured risk exposures does not 
provide the backstop that supervisors need to ensure that each 
institution has the appropriate capital in place before the 
unexpected loss occurs. Capital should be based on risk 
exposures, and the evolving risk-modeling methodologies provide 
improved tools to better determine the appropriate level of 
capital.
    That is why the Basel II framework contains minimum 
regulatory capital requirements in Pillar 1, to tie risks to 
levels of capital. In Pillar 1, the framework seeks to achieve 
a balance between risk sensitivity and prudence by building on 
certain firm-specific inputs, but deriving capital outputs from 
a regulatory prescribed capital model. Pillar 1 is, of course, 
complemented by Pillar 2 (supervisory review) and Pillar 3 
(market discipline). Together, the three pillars should provide 
banks with the appropriate incentives to move toward leading 
risk-measurement practices and provide supervisors and the 
marketplace with a conceptually sound framework for assessing 
how capital and risk evolve over time, which 
institutions are outliers, and, ultimately, whether the banking 
system is becoming more or less sound from a capital adequacy 
perspective.

Q.14. Have you compared the capital requirements for the 
participating banks that came out of your Quantitative Impact 
Study with the judgments of your professional bank examination 
staff on the capital needs of those same banks? How closely 
correlated were the results?

A.14. The QIS-4 exercise involved not just Basel II experts 
from within the U.S. banking agencies, but also members of the 
on-site teams responsible for day-to-day supervision of the 
entities participating. On-site supervision staff received and 
reviewed the information submitted in QIS-4 by their respective 
institutions. But, they did not review the measurement systems 
and methodologies used by the banks to construct the 
information. The incorporation of on-site teams into the QIS-4 
process is consistent with our overall objective of 
``normalizing'' Basel II work into regular supervision for 
relevant institutions as we move closer to implementation. A 
major portion of the QIS-4 exercise was a qualitative 
questionnaire filled out by participating institutions, in 
which they described what stood behind the numbers they 
produced (the data sources, methodologies, etc.). On-site teams 
were asked to compare their knowledge and understanding of the 
institution with what was contained in the questionnaires.
    In general, on-site supervision staff agreed with the 
conclusions of Basel II experts about the QIS-4 results namely, 
that the drop in QIS-4 required minimum risk-based capital was 
largely due to the favorable point in the business cycle, and 
the dispersion among institutions was largely due to the 
varying risk parameters and methodologies they used. 
Importantly, we also learned that some of the data submitted by 
individual institutions was not complete; in some cases banks 
did not have estimates of loss in stress periods or used ad hoc 
estimates, which might have caused minimum regulatory capital 
to be underestimated. As we have said before, we would not be 
comfortable qualifying any institution for Basel II based on 
QIS-4 results, since it was just a point-in-time look at how 
banks are progressing and was conducted on a ``best-efforts'' 
basis, rather than in ``full compliance'' with the Basel II 
rules, without the benefit of additional supervisory oversight. 
In the future as banks move to the parallel run and prepare to 
qualify for Basel II certification, the supervisory oversight 
process will play a significant role in determining whether the 
measurement and risk management systems used by the 
participating banks are consistent with the Basel II 
requirements. There is obviously more work to be done. The 
recognition of the amount of work still required is reflected 
in the U.S. agencies' plan for a one-year delay before Basel II 
is implemented and a one-year extension of transitional floors 
once it is.

Q.15. Basel II represents an attempt to apply the same formulas 
for measuring commercial loan credit, consumer loans, and 
commercial real estate loan risk to banks in the United States 
and to banks in other developed countries. What evidence do you 
have that the formulas will assure that U.S. banks will hold 
sufficient capital to see them through a variety of economic 
scenarios, such as those that have occurred in the United 
States over the last 25 to 50 years? Are the markets and 
economic environment similar enough that the same formulas can 
be applied safely to large banks from the United States, 
Canada, the United Kingdom, France, Germany, Japan, etc.?

A.15. The Basel II framework contains formulas for calculating 
risk weights based on bank inputs. In developing Basel II, it 
was necessary to create ``average'' risk-weight functions to 
apply across countries that plan to implement it. While these 
formulas do not necessarily fully capture each institution's 
risk profile perfectly, they are the best approximation at this 
time for producing similar capital requirements given similar 
risks across a range of institutions. One of the key features 
of the Basel II framework is that many specifics with respect 
to implementation are left to national discretion. As a result, 
certain aspects of the framework, which could include some 
parts of the formulas, will be tailored to national 
jurisdictions. Moreover, to the extent that there are 
differences in the risk-taking of banking institutions across 
the major developed countries, the Basel II framework was 
designed to take these differences into account through the 
resulting differences in bank-provided risk parameters, 
including estimates of probability of default, loss given 
default, and exposure at default.
    Given that the Basel II framework is risk sensitive, 
minimum regulatory capital requirements should be expected to 
fluctuate to a certain extent as economic conditions change. 
This aspect of the framework is necessary and desirable, 
sending signals to both banks and supervisors about changing 
credit conditions and potentially aiding the evaluation of the 
relationship between actual and minimum capital levels at any 
point in the economic cycle. That said, the Federal Reserve is 
working diligently to ensure that U.S. banks will hold 
sufficient capital to see them through a variety of economic 
scenarios. Indeed, the framework has been constructed with 
safeguards in Pillars 1, 2, and 3 to help ensure that minimum 
capital requirements remain prudent at all points in the 
economic cycle. As we gain additional experience from banks' 
implementation of the revised framework, we will continue to 
assess the adequacy of the framework, including the behavior of 
minimum capital requirements over the economic cycle. We also 
will have other supervisory tools to use in conjunction with 
Basel II, things like the 
leverage ratio and PCA.
    As part of the U.S. rulemaking process, the U.S. agencies 
are seeking comment on the entire framework, including its 
formulas, to determine its appropriateness for U.S. 
institutions. The U.S. agencies have already demonstrated their 
willingness to deviate from other countries' implementation 
strategies by extending the start date for Basel II in the 
United States and calling for an additional year of 
transitional floors. And, should it become necessary, the 
Federal Reserve would be prepared to consult with our 
colleagues at home and in other Basel member countries to make 
changes to the framework itself, in keeping with the objective 
of ensuring the safety and soundness of the U.S. banking 
system.

Q.16. The agencies' current transitional plan for implementing 
Basel II contemplates allowing capital levels to fall to an 85 
percent ``floor''. How can the agencies know, even before the 
``parallel run'' contemplated for 2008, that a drop of 15 
percent in the capital of banks would be consistent with safety 
and soundness considerations?

A.16. It is important to remember that the floors described in 
the Basel II proposals apply to individual institutions, not 
the banking system as a whole. The floors require a financial 
institution to hold capital at the higher of the minimum 
regulatory capital determined by its risk models or the 
transition floor. It is only when an individual institution can 
demonstrate to supervisors that it has a lower risk profile 
than Basel I implies, that supervisors will then consider 
allowing that institution's minimum regulatory capital to 
decline to the floor levels proposed under Basel II. And after 
the 3 years of floors, supervisors will continue to monitor 
institutions' risk profiles to see if the declines in minimum 
regulatory capital are still warranted. Of course, for some 
institutions, minimum regulatory capital may increase under 
Basel II--reflecting the greater risk sensitivity of the new 
framework.
    Additionally, the implementation of Basel II will progress 
in stages, and only after supervisors achieve comfort at the 
end of each stage will we move on to the next. The agencies' 
response to QIS-4 is a good example of how we took extra time 
before moving forward, and then did so with a revised plan. We 
expect to use the same type of prudence for the period of 
transitional floors, and by that time we will have much more 
information than today about Basel II and its effects. Even 
before moving to the transitional floors, banks will have to 
demonstrate their ability to produce credible Basel II minimum 
capital measures; that is, they will be able to move to the 
first year of floors only if the primary supervisors are 
satisfied with what they see during the parallel run. The first 
year of floors is set at 95 percent (implying at most a 5 
percent decline for any given institution). If the primary 
supervisors are not comfortable with a bank moving to the 
second-year floor (at 90 percent), they might retain the 95 
percent floor for that institution. Similarly, primary 
supervisors will have to give approval for an institution to 
move from the 90 percent to the 85 percent floor. The primary 
supervisors will also have to approve a banking institution 
moving from the 85 percent floor to full implementation without 
a floor.

Q.17. Basel II's capital formulas are based on highly complex 
models that are to be implemented on a bank specific basis. 
While Basel I has been criticized for its oversimplification, 
the sheer complexity of Basel II has raised some very serious 
concerns. In his written testimony, Mr. Isaac states, ``Basel 
II is so complex it cannot be adequately understood by senior 
bank managements, boards of directors, regulators, or the 
public.'' Professor Kaufman states, ``Increased complexity is 
likely, however, to both increase compliance costs and reduce 
understanding, particularly by the bank CEO, board of 
directors, and possibly even the CFO and by bank supervisors.'' 
Do you share Mr. Isaac's and Professor Kaufman's concerns? If 
you share their concerns, what recommendations do you have for 
the regulators as to how to fix this problem?

A.17. Basel II is designed to reflect the risk-management 
practices of large, internationally active financial 
institutions. These institutions have become more complex in 
the sophistication of their services and business practices, as 
well as in their organizational structures. As a result, 
effective risk management has been evolving to support these 
innovative financial structures. Indeed, Basel II may not look 
that complex to many of the risk managers at institutions 
today. Most banking organizations involved in complex financial 
instruments should already possess an understanding of advanced 
risk concepts and should have implemented effective risk-
measurement and -management practices. Indeed, the largest, 
most complex institutions in the United States are already 
employing 
models as complex as, or more complex than, those in Basel II, 
underscoring the need to move to a capital adequacy framework 
that is more closely aligned with how banks measure and mange 
risk internally.
    As prudent supervisors, all of the U.S. banking agencies 
require any organization employing sophisticated financial 
practices or using complex financial instruments to have 
adequate risk management to address its risk positions, as well 
as governance and control structure commensurate with those 
activities. This includes having knowledgeable staff to set 
risk limits effectively, and clearly communicate risk positions 
and risk-management strategies to executive management and 
boards of directors.
    The advanced approaches of Basel II are complex and have 
many moving parts, which is one of the reasons that in the 
United States we are proposing to require only the largest, 
most sophisticated financial institutions to adopt Basel II. 
For these organizations, the incremental cost of adopting Basel 
II advanced approaches, while admittedly significant, should be 
relatively modest compared with the significant risk-management 
investments they have already made.
    It is our view that via increased disclosures as part of 
Pillar 3, Basel II will actually augment the general 
understanding of banks' capital adequacy in relation to 
underlying risks by providing increased information on banks' 
risks and how they are measured and managed.

Q.18. According to FDIC data, the equity to capital ratio of 
insured U.S. financial institutions reached a low of slightly 
above 5 percent in the late 1980's, during the S&L crisis, and 
then rose steadily through the 1990's reaching the level of 
over 10 percent, at which it stands today. Profits--as measured 
by return on assets--which had fallen dramatically during the 
period of low capital, also began a steady rise in the 1990's, 
rising to well over 1 percent for the last decade, reaching 
record levels. When looked at together, it becomes clear that 
large profits and strong levels of capital can coexist. Do you 
agree that strong levels of banks capital can and do coexist 
with strong bank profitability?

A.18. Profitability has a direct relationship to capital 
levels. As banks' profits recovered in the early 1990's, the 
amount of earnings retained after paying out dividends also 
rose. Retained earnings contribute significantly to increased 
levels of equity and total capital.
    Profitability and healthy capital levels are both important 
to a safe and sound banking system. Earnings and capital 
adequacy are two components of the FFIEC's CAMELS supervisory 
rating system. Strong and consistent profits provide 
competitive returns to shareholders and allow for internal 
generation of capital while healthy capital levels allow banks 
to weather potential adverse conditions, protecting the deposit 
insurance funds and aiding funding and liquidity by making the 
bank more attractive to market participants as a counterparty. 
Moreover, strong capital means that bank owners have a 
significant stake in ensuring that the institution is managed 
in a prudent manner. Consistently strong earnings and capital 
also suggest that institutions have prudently balanced their 
appetite for risk-taking with return, an objective that the 
Federal Reserve believes will be further advanced by the Basel 
II framework.
    The chart below depicts aggregate capital ratios and 
profitability (measured as return on assets, or ROA) for 
insured commercial banks in the United States since 1984. The 
lines in the chart show three capital measures, including a 
simple equity-to-assets ratio and, since the implementation of 
the 1988 Basel Accord (which took effect in 1992), the more 
risk-sensitive total risk-based capital ratio and the Tier 1 
leverage ratio.




    In the late 1980's, the simple equity-to-assets ratio was 
just a little over 6 percent. The implementation of the Basel 
Accord and the PCA framework in the United States were part of 
a broader supervisory emphasis on strengthening capital 
positions. The positive 
results of this emphasis are borne out by steady increases in 
equity-to-assets and leverage ratios over time, and aggregate 
risk-based capital ratios that are well in excess of minimum 
standards. Implicit in the aggregate data shown here is that 
nearly all insured commercial banks have consistently 
maintained regulatory capital ratios that exceed minimum 
standards for being well-capitalized under the PCA framework.
    Profitability also improved in the 1990's for many reasons, 
including recovery from the downturn in commercial real estate 
in the 1980's, innovation and the growth of new business lines, 
expansion of bank activities in the capital markets arena, and 
improved operating efficiency.
    On balance, strength in both profitability and capital 
levels is important to the soundness and resiliency of a 
banking system. During the most recent economic downturn, 
capital and reserve levels provided a cushion for banks to 
absorb losses and weather the credit cycle. Banks that are 
strongly capitalized may enjoy greater flexibility and a 
broader range of choices in how to handle adverse credit or 
operational conditions. That ultimately may have a beneficial 
impact on their long-term profitability.

Q.19. Under the Administrative Procedure Act, agencies are 
required to consider public comment prior to issuing new final 
regulations. How can the agencies fully comply with this 
requirement? Doesn't the fact that the agencies reached an 
international agreement on the new capital framework 
effectively limit their ability to fully consider public 
comment and modify proposed regulations in light of that 
comment?

A.19. The Federal Reserve has been, and intends to continue, 
complying fully with the letter and spirit of the 
Administrative Procedure Act (APA) in connection with the 
pending U.S. rulemaking to implement Basel II. Although not 
required by the AP A, the US. banking agencies issued an ANPR 
on the U.S. implementation of Basel II in August 2003 to ensure 
that any proposals by the agencies to implement Basel II in the 
United States would reflect comments from banking 
organizations, Members of Congress, and other interested 
parties.\1\ Comments received on the ANPR influenced 
significantly the June 2004 Basel II document agreed to by the 
U.S. banking agencies and other G--10 bank supervisory 
authorities and will influence in important ways the 
forthcoming NPR on the United States implementation of Basel 
II. We note that the Basel II framework has changed 
considerably since the first proposal by the Basel Committee in 
the late 1990's, in material part due to the valuable comments 
of U.S. financial institutions and other interested parties in 
the United States.
---------------------------------------------------------------------------
    \1\ 68 Federal Register 45900 (August 4, 2003).
---------------------------------------------------------------------------
    The June 2004 Basel II document is not a binding agreement 
that has the force of law in the United States. In addition, 
while it lays out important principles, it leaves to national 
discretion much of the specific details regarding 
implementation. The U.S. agencies expects that the forthcoming 
NPR would be generally consistent with the June 2004 Basel II 
document but likely will vary in some of its details from the 
June 2004 Basel II document to accommodate some special 
features of U.S. banking organizations and the U.S. financial 
markets. In addition, if comments received on the NPR suggest 
that changes should be made to the June 2004 Basel II document 
or to any U.S. final rule that implements Basel II, the Federal 
Reserve will work with the appropriate parties to make those 
changes.
    Although not required by the APA, the Federal Reserve and 
the other U.S. banking agencies also have sought public comment 
on a draft of the supervisory guidance that would accompany any 
U.S. rule that implements Basel II.\2\ The agencies have 
revised this draft guidance to reflect comments from U.S. 
banking organizations and intend to seek a second round of 
comments on the 
guidance soon after issuance of the NPR. The agencies have 
endeavored, and will continue to endeavor, to be as transparent 
as possible about all aspects of Basel II implementation in the 
United States, including the important risk-measurement and -
management infrastructure requirements of the Basel II 
framework.
---------------------------------------------------------------------------
    \2\ 68 Federal Register 45949 (August 4, 2003: 69 Federal Register 
62748 (October 27, 2004).
---------------------------------------------------------------------------
    Finally, it is useful to remember that Basel I has been 
amended 28 times in the United States since it was introduced, 
often in order to keep up with advancements in the industry; 
the recent changes relating to certain securitization 
transactions are a good example. Today's U.S. Basel I rules 
differ from Basel I rules in other countries, appropriately 
reflecting the characteristics of national banking systems. We 
expect to tailor Basel II rules to the U.S. environment in a 
similar fashion.

Q.20. The Basel II framework ignores a significant risk: 
Interest rate risk. Many banking assets, such as mortgage 
servicing rights, are extremely sensitive to changes in 
interest rates, and the value of assets such as these may 
fluctuate dramatically when interest rates change. How do you 
propose to take interest rate risk into account under the Basel 
II framework?

A.20. The Basel II framework addresses interest rate risk 
substantively as part of the Pillar 2 process. Specifically to 
support the Pillar 2 approach, the Basel Committee issued in 
July 2004 a paper, ``Principles for the Management and 
Supervision ofInterest Rate Risk.'' This paper combines a 
principles-based approach along with a quantitative benchmark. 
The first 13 principles address the need for effective interest 
rate risk measurement, monitoring and control functions within 
the interest rate risk management process. Principles 14 and 15 
address the supervisory treatment of interest rate risk in the 
banking book.
    The paper provides guidance to help supervisors assess 
whether internal measurement systems are adequate. If 
supervisors determine that a bank has insufficient capital to 
support its interest rate risk, they must require either a 
reduction in the risk or an increase in the capital held to 
support it, or a combination of both. Supervisors are cautioned 
to be particularly attentive to the capital sufficiency of 
``outlier banks''--those whose interest rate risk in the 
banking book leads to an economic value decline of more than 20 
percent of the sum of Tier 1 and Tier 2 capital following a 
standardized interest rate shock or its equivalent. Individual 
supervisors may also decide to apply additional capital charges 
to their banking system in general.
    In practice, the approaches developed in this paper, 
supporting Pillar 2, are consistent with the existing 
supervisory practices of the Federal Reserve and other Federal 
banking and thrift regulators. Additionally, if the agencies 
begin to see evidence that the existing treatment of interest-
rate risk in Basel II is inappropriate, inaccurate, or 
inadequate, they can propose changes.

Q.21. Due to the tremendous devastation caused by Hurricanes 
Katrina and Wilma this fall, it is estimated that over 100,000 
homes have been lost. Would the Basel II framework have 
provided institutions with enough capital buffer to handle a 
calamity of this magnitude?

A.21. Over the past several years, as part of broader risk-
management improvements, banks have been upgrading business 
continuity and contingency planning for natural disasters or 
other large-scale events. Preparations for Y2K, lessons learned 
from September 11, and experience with recent natural disasters 
have aided in these efforts. We believe that Basel II would 
provide even more benefits to institutions in this particular 
area because of its expected risk-management enhancements. 
These enhancements would likely apply to managing both 
operational risks and credit risks. For example, institutions 
should plan for the possibility that their business operations 
could be disrupted by a natural disaster in a certain location. 
Similarly, as they estimate possible losses during stress 
conditions, institutions should take into account their credit 
risk concentrations and the possibility that obligors in an 
entire geographic area could be adversely affected and suffer 
economic and financial difficulties. In fact, as part of their 
work related to Pillar 2, institutions should conduct analyses 
of the buffer they hold above minimum regulatory capital levels 
to ensure that actual capital held reflects all risks to which 
that individual institution is exposed. In general, Basel II 
should provide institutions with a better sense of the capital 
needed to support risks associated with natural disasters or 
other large-scale stress events than they currently have, as 
well as an improved ability to manage those risks.

Q.22. Last week, on November 18, 2005, the Financial Times 
published an editorial by Harold Benink and Jon Danielsson 
titled, ``There is a Chance to Correct the Defects of Basel 
II.'' Harold Benink is Professor of Finance at RSM Erasmus 
University in the Netherlands. Jon Danielsson is Reader in 
Finance at the London School of Economics. They concluded: 
``Instead of requiring bank capital to be risk sensitive, 
banking regulation should simply require the use of high 
quality risk models in banks without using their output to 
determine capital. Minimum capital is better calculated as a 
simple fraction of bank activity in broad categories.'' What is 
your response to this suggestion?

A.22. See response to question 13. Regarding the suggestion 
that minimum regulatory capital is better calculated as a 
simple fraction of bank activity in broad categories, this is 
essentially what the current Basel I capital framework does. 
However, the Federal Reserve believes that this simple 
framework has become increasingly inadequate for large, 
internationally active banks offering ever-more complex and 
sophisticated products and services. Today's capital framework, 
left unchanged, could eventually undermine the safety and 
soundness of the financial system. It encourages banks to hold 
on to high-risk assets and shed low-risk assets and does not 
provide incentives for better risk-management techniques and 
processes.
    Basel II builds on the risk-management approaches of well-
managed banks and creates strong incentives for banks to move 
toward leading risk-measurement and -management practices. It 
establishes a coherent relationship between how supervisors 
assess regulatory capital and how they supervise the banks. 
Thus, it will 
enable examiners to better evaluate whether banks are holding 
prudent capital levels, given their risk profiles, and to 
better understand differences across institutions. For safety 
and soundness purposes, prudential supervision requires that 
sound bank management requires the ability to model and measure 
risk, and that minimum regulatory capital reflect the amount of 
risk exposure that the individual institution chooses to 
accept.

Q.23. In his testimony, Mr. Isaac states, ``I have not found a 
single professional bank supervisor who is enthusiastic about 
Basel II.'' We have also heard of a similar lack of enthusiasm 
on the part of the supervisors who will actually be responsible 
for supervising Basel II. What is your response? Separately, 
what gives you confidence that regulators will be up to the 
task of understanding and policing Basel II?

A.23. In our view, most U.S. bank supervisors are enthusiastic 
about risk-management improvements expected through the 
application of Basel II and fully support the concepts behind 
the framework. In fact, supervisors already work with bankers 
at large, 
complex institutions to advance their ability to employ more 
sophisticated and quantitative risk measures and corresponding 
risk-management practices. While this is the first time that we 
are using bank inputs as determinants of minimum regulatory 
capital requirements for credit and operational risk exposures, 
we do have the experience of the Market Risk Amendment, which 
has been implemented successfully in terms of promoting better 
risk management and measurement of market risk exposures. That 
said, bank supervisors, as a group, are skeptical and cautious-
indeed, they are trained to be so. So it not surprising that 
some bank supervisors would have some reservations about 
immediately adopting a new capital framework whose full effects 
are not yet known. Furthermore, U.S. bank supervisors will want 
to ensure that the risk-measurement and -management 
improvements expected through the application of Basel II 
actually prove fruitful before allowing institutions to use 
internal inputs for regulatory capital.
    Accordingly, the U.S. agencies are taking a careful and 
deliberate approach to adopting Basel II in this country, and 
will continue to review and analyze its potential impact with 
each successive step in the process. The extensive comment 
period, the parallel run, the transitional floors, the 
opportunity for additional review and analysis, and additional 
rulemakings all indicate that we will not move to Basel II 
unless we have solid evidence that it is meeting its objectives 
and promoting safety and soundness of the U.S. banking system. 
During each of these stages, supervisors will have full 
access to institutional information, including data sources and 
methodologies, in order to render a judgment about banks' 
preparedness. The input from these supervisors will continue to 
be a critical component of the judgments about elements of the 
Basel II proposal as well as individual bank's readiness to 
move to Basel II.
    We should also note that U.S. bank supervisors have for 
many years been involved with analyzing and examining 
sophisticated risk-measurement and -management practices at 
large, complex organizations. At many levels, our examination 
staff has experience with practices similar to or even more 
sophisticated than those described in Basel II. Our knowledge 
and experience gives us some confidence in both the banks' 
abilities to achieve the risk-measurement and -management 
enhancements expected in Basel II, as well as confidence in our 
own ability to supervise banks under Basel II. But as always, 
we, as good supervisors, will still need to see actual results 
before we can be completely comfortable.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY 
                     FROM DONALD E. POWELL

Q.1.a. Basel II would impose new demands on bank regulators. It 
would require bank regulators to not only approve banks' 
internal assessments of their risks, but also to make judgments 
on whether banks are holding enough capital in light of all the 
risks banks face. This means bank regulators are going to need 
personnel who are well-trained in risk analysis.
    How many additional personnel does your agency expect it 
will need to hire in order to implement Basel II? What type of 
expertise will your agency need to obtain? Do you foresee any 
problems in recruiting?

A.1.a. The FDIC's staffing needs relative to Basel II derive 
from two roles: (i) its role as primary Federal banking 
supervisor of 
insured depository institutions that opt-in to Basel II, or 
that otherwise adopt Basel II by virtue of being bank 
subsidiaries of organizations that are required to adopt Basel 
II; and (ii) its role as deposit insurer of other banks 
adopting Basel II.
    It is anticipated that most of the staffing needs relative 
to Basel II derive from the first role. There are roughly 20 
FDIC-supervised insured banks that have either expressed an 
interest in opting in to Basel II or are subsidiaries of 
mandatory banking organizations. Basel II implementation for 
these banks will involve a hybrid supervisory approach whereby 
traditional examiner judgment and risk analysis skills will be 
supplemented with targeted quantitative review of risk 
management models.
    Our approach to meeting our Basel II staffing needs is to 
reallocate and train existing examiners that already possess 
sound risk analysis and judgmental capabilities, and target 
other specialists to address non-traditional examination 
functions. This has been supplemented with a limited amount of 
external hiring of individuals with academic or practitioner 
backgrounds in quantitative risk measurement. Appropriate 
staffing levels, as well as the efficiency and effectiveness of 
internal processes, will continue to be monitored on an on-
going basis. We anticipate additional staffing requirements as 
the implementation process goes forward.

Q.1.b. Will your agencies be able to successfully compete 
against banks in the recruitment of personnel? Do you have any 
concerns that banks will simply be able to hire the best 
Ph.D.'s in risk modeling and outgun their regulators?

A.1.b. In part because of their ability to offer more lucrative 
compensation packages, large banks will indisputably enjoy 
certain 
advantages in recruiting qualified and motivated risk modeling 
professionals both from the private sector and from regulatory 
agencies. This is by no means a new issue created by Basel II, 
but it may become more pronounced in the coming years as banks 
build out required Basel II systems.
    Two countervailing considerations must be kept in mind, 
however. First, the agencies have traditionally been able to 
attract and retain highly qualified individuals, in both 
traditional examination disciplines and more quantitative 
disciplines, for whom public service is a satisfying career 
path. Second, it must be emphasized that the evaluation of 
proprietary bank models will be a defined and narrow subset of 
overall Basel II implementation activities. Traditional 
examination functions of assessing overall risk, adequacy of 
banks systems, internal controls, and management oversight will 
continue to play a lead role in the overall supervisory 
process.

Q.1.c. How much in additional annual costs do you expect to 
incur in implementing Basel II? Other than personnel costs, 
what other costs will your agency incur in implementing Basel 
II? Are there any large one-time costs?

A.1.c. It is difficult to isolate implementation costs related 
to Basel II, in part because Basel II represents only one 
aspect of the overall increasing complexity associated with the 
supervision and insurance assessment of large insured 
depository institutions.
    Over the next few years, the FDIC's costs will be primarily 
associated with staff time devoted to the rulemaking processes, 
guidance development and training, industry outreach, and on-
site 
examination processes. The cost associated with recruiting and 
retaining qualified staff will also likely increase in the 
coming years.

Q.2.a In his testimony, Dr. Tarullo posed several questions 
that he believes need to be answered by U.S. banking agencies 
before implementation of Basel II begins. Please provide 
answers to his questions with respect to your agency, which are 
as follows: ``Do the agencies believe that, in general, minimum 
capital levels are too high and, if so, what is the basis for 
that belief ?

A.2.a. The FDIC does not believe that minimum capital levels 
are too high. There is little evidence that the historically 
high capital levels in the United States have limited business 
opportunities for banks or the availability of credit. Indeed, 
the industry as a whole has had record earnings over the past 
few years.
    Market analysts also do not believe that lowering capital 
standards would benefit the industry. For example, Standard & 
Poor's recently (November 30, 2005) released a report on ``Bank 
Industry Risk Analysis: United States.'' In that report, the 
analysts observed that ``A final uncertainty for the capital 
strength of the sector is the adoption of the Basel II capital 
accords. While Standard & Poor's wholeheartedly endorses 
efforts to link capital levels and risk, we do not believe that 
the industry as a whole is overcapitalized. For this reason, 
material reductions in capital would be viewed as a negative 
for the industry's strength.''

Q.2.b. Have the agencies been able to predict with reasonable 
precision the levels of capital that the A-IRB approach will 
require of large banks, and then to confirm their prediction 
through studies that are well-conceived and executed?

A.2.b. No. There are diverging views about the levels of 
capital that the A-IRB approach will ultimately require of 
large banks. There have been a number of major interagency 
studies of this issue in which potential adopters of Basel II 
provided their own 
estimates of specified risk parameters to lengthy and detailed 
spreadsheets designed to calculate the resulting A-IRB capital 
requirements. The results of such studies remain subject to 
considerable uncertainty, as discussed below.
    The agencies have stated an expectation that capital 
requirements under the advanced approaches of Basel II would 
not, on 
average, be substantially less than current risk-based capital 
requirements, although capital requirements for individual 
banks might show more variation based on their risk profiles.
    The two most recent Quantitative Impact Studies, QIS-3 
conducted in 2002-2003, and QIS-4 conducted in 2004-2005, 
reported, based on banks own estimates, average reductions in 
risk-based capital requirements of 6 percent and 15.5 percent 
respectively for the participating U.S. banks.
    A number of points need to be considered in evaluating 
these estimates. First, the data on which they are based is 
imperfect, based as they are on bank systems and models that 
are in various stages of development, and made in many cases 
without a clear understanding of what the Basel II systems 
requirements and supervisory expectations ultimately will be. 
Some observers have pointed in particular to a lack of 
compliance by QIS-4 reporters with requirements to incorporate 
stressed conditions and economic losses into estimates of loss 
given default, tending, at least from this consideration alone, 
to understate capital requirements.
    Second, QIS-3 was conducted closer to a period 
characterized by recession conditions in the corporate sector 
while QIS-4 was conducted during more benign economic 
conditions. From this difference alone one would expect a 
greater reduction in capital 
requirements to be reported in QIS-4 than was reported in QIS-
3. This, in fact, was the case.
    Third, most QIS-4 banks reported their exposures as if they 
received no capital benefit from guarantees, collateral, or 
hedging, because their information systems were not yet 
configured to allow them to do so. Were the systems in place to 
allow the banks to benefit from the credit risk mitigation 
already in place, the reductions in reported capital 
requirements would have been greater, at least from this factor 
alone.
    Fourth, the FDIC has published analysis that suggests that 
both QIS-3 and QIS-4 fundamentally overstated the capital 
requirements likely to be produced by Basel II, once it is 
actually up and running. This analysis has argued that 
participating banks in both studies used risk inputs that were, 
on average, more conservative than what the Basel II framework, 
taken literally, would appear to require. Details of this 
analysis are available in an article in the FDIC's ``FYI'' 
series published in December 2003, and in appendix B of 
Chairman Powell's November 2005 testimony before the Senate 
Committee on Banking, Housing, and Urban Affairs.
    Finally, it should be noted that the magnitude of reduction 
in capital requirements depends significantly on both the 
capital concept being used and the measurement concept being 
used. The QIS-4 aggregate results described above refer to the 
average reduction--5.5 percent--in total capital requirements. 
The median reduction, in contrast, was 26 percent. The 
reductions in tier 1 capital requirements (tier 1 capital 
excludes loan loss reserves, most subordinated debt, and other 
elements not fully available to absorb losses on a going-
concern basis) were greater. The average QIS-4 reduction in 
tier 1 capital requirements was 22 percent and the median 
reduction in tier 1 capital requirements was 31 percent.

Q.2.c. Have the agencies done scenario planning to anticipate 
the effects, unintended and otherwise, of Basel II upon the 
financial system as a whole? For example, are significant 
portions of certain kinds of assets likely to migrate out of 
banks into the unregulated sector? If so, might new risks of 
financial disruption be created?

A.2.c. There is little research on the effect of regulatory 
capital standards on competition within the broader financial 
industry. It is difficult, if not impossible, to disentangle 
the effects of capital standards from other differences between 
segments of the industry. For example, over the past 5 or 10 
years, securities affiliates of banks have gained market share 
at the expense of more traditional securities firms. The 
reasons for this shift are not clear but this trend at any rate 
does not suggest that these large banking organizations have 
suffered from a regulatory capital disadvantage to date. Going 
forward under Basel II, it is not clear whether there would be 
any important classes of assets that would be forced to be 
capitalized at higher levels within a bank than would be the 
case if those assets were financed outside the Federal safety 
net.

Q.2.d. What do the agencies regard as the effective capacity of 
the specialized examiner teams that will be overseeing the use 
of bank models under A-IRB? How will the agencies determine 
whether other countries are successfully monitoring bank 
capital levels under the A-IRB approach?

A.2.d. It should be noted that ``overseeing the use of bank 
models under A-IRB'' will be but one aspect of Basel II 
reviews, and this process is not new to regulators (for 
example, market risk reviews). The FDIC has established 
examination programs and processes designed to assess all 
material risks within an institution. These existing processes 
will be tailored to incorporate Basel II qualification and 
ongoing validation through the implementation of appropriate 
guidance, procedures, and training, as well as recruitment or 
reallocation of specialized resources.
    With regard to international processes, the FDIC and other 
U.S. regulatory agencies have fostered sound supervisory 
working relationships with many jurisdictions. The FDIC is 
actively involved in international working groups focused on 
Basel II implementation issues, such as the Accord 
Implementation Group (AIG), to ensure that high-level 
principles and protocols are established and that key issues 
are raised in an effort to reach convergence. Additionally, 
many jurisdictions, including the United States, have 
established ``supervisory working groups'' as a forum to vet 
key implementation issues at the staff level.

Q.2.e. Have the banking agencies consulted with institutional 
investors, ratings agencies, independent analysts, and other 
market actors concerning the amount of information about their 
credit modeling that A-IRB banks will be required to disclose? 
[If so, what were the views of these market factors as to the 
adequacy of the contemplated disclosure requirements?]

A.2.e. The agencies have consulted with investors, analysts, 
and ratings agencies regarding the disclosures for Basel II A-
IRB banks through the Basel II ANPR and the Basel consultative 
papers which included solicitations for comment on the 
disclosure 
requirements. In addition, we encourage the industry to provide 
comment on market disclosures following the publication of the 
Notice of Proposed Rulemaking.
    The agencies have previously sought input on the disclosure 
requirements through meetings with banks, ratings agencies, and 
other groups in connection with our participation on the Basel 
Committee's Transparency Group. The investor and rating agency 
communities have been generally supportive of the agencies' 
proposed disclosures. In addition, on June 4, 2002, the FDIC 
sponsored the ``Enhancing Financial Transparency'' symposium, 
which provided a forum for leading experts from the private and 
public sectors, including Wall Street experts, to discuss 
issues pertaining to market transparency and disclosure. 
Further, on July 31, 2002, the FDIC cosponsored the ``Rise of 
Risk Management: Basel and Beyond'' symposium with Credit 
Suisse First Boston that also included a discussion of 
disclosure policy as it relates to Basel II.

Q.2.f. Do the banking agencies continue active study of 
alternative approaches to capital regulation, such as the 
varieties of proposals based on market discipline or on so-
called precommitment?

A.2.f. In the Basel II Advance Notice of Proposed Rulemaking 
(ANPR) published in August 2003, the agencies indicated that if 
further analysis or comment suggested there would be 
significant unintended competitive ramifications as a result of 
the adoption of a bifurcated regulatory capital framework, the 
agencies would consider changes to both the general domestic 
capital rules as well as changes to the Basel II framework. The 
further analysis and comments received since that time have not 
caused the agencies to 
consider changes to the Basel II framework. Consequently, the 
agencies' efforts continue to be focused on the domestic 
rulemaking process for Basel II and the modification of current 
risk-based capital rules. Market discipline is included as one 
of the key aspects in the Basel II framework, the ``third 
pillar'' that requires public disclosures of Basel II 
information for each institution.

Q.3. Although Basel I-A aims to reduce any competitive 
advantage Basel II may confer on large banks, have you 
conducted any analysis to determine whether Basel I-A itself 
creates any competitive issues within the subset of banks that 
are intended to be covered by it? If not, do you intend to do 
so?

A.3. ``Basel I-A'' refers to the agencies' publication of an 
advance notice of proposed rulemaking (ANPR) that seeks 
industry comment on a wide variety of issues including 
competitive inequities and regulatory burden.
    The ANPR proposes modifications to the existing risk-based 
capital rules where quantitative factors used to measure the 
risk associated with a given product or exposure can be readily 
articulated. However, there are certain areas where risk-
measurement factors are not well-defined or universally 
applied, such as with unrated commercial loans and certain 
retail loans. The agencies have requested comments in those 
areas. As a result, the agencies will wait until the comments 
received on the ANPR have been thoroughly analyzed before more 
fully developed risk-based capital proposals can be considered. 
Until the ANPR comments have been analyzed and more definitive 
proposals developed, it is probably premature to speculate 
about competitive effects within the subset of banks operating 
under Basel I-A.
    Notwithstanding, the FDIC is concerned with competitive 
issues among various Basel I-A institutions as well as between 
Basel I-A and Basel II institutions. To seek more information, 
the FDIC placed the following request in the Financial 
Institution Letter that transmitted the ANPR to FDIC-regulated 
institutions:

    The FDIC recognizes that the proposals under consideration 
might not be suitable to the entire universe of institutions 
that will most likely not adopt the Basel II approaches. 
Institutions vary considerably in size and capital levels. Some 
institutions may be more inclined to remain on the existing 
risk-based capital framework rather than adopt a more risk-
sensitive framework.
    The FDIC encourages all commenters to carefully consider 
the implications of the proposals included in the ANPR. In 
addition to comments on the specific proposals set forth in the 
ANPR, the FDIC welcomes any alternatives or suggestions that 
would facilitate the development of fuller and more 
comprehensive proposals applicable to a range of activities and 
exposures.

    The FDIC believes that the industry will provide 
significant feedback should the proposals included in the Basel 
I-A ANPR suggest that competitive equity issues may arise 
between Basel I-A institutions.

Q.4. What consideration has been given to the fact that there 
are huge differences between the 7,000 or so banks that will 
participate in the Basel I-A framework?

A.4. The FDIC believes that the Basel I-A framework should be 
designed to reduce the competitive inequities associated with 
Basel II while ensuring that capital remains adequate for the 
risks inherent in these institutions. However, since the 
beginning of the Basel I-A process, the FDIC has realized that 
these stated goals are difficult given the large disparity in 
asset size and operating complexity associated with the 8,000+ 
institutions that would apply the Basel I-A framework. The FDIC 
wants to ensure than any additional burden that could be 
generated by these proposals is commensurate with the benefit 
derived.
    Therefore, in drafting the Basel I-A ANPR, the FDIC 
proposed that a great deal of flexibility be included in the 
proposals. For example, the ANPR sought comment on whether 
certain banks, especially community banks operating with 
capital ratios well in excess of their minimums, should be 
given the flexibility to opt out of the Basel I-A framework in 
whole or in part.

Q.5. In Dr. Kaufman's testimony, he stated that there is 
``substantial empirical evidence of a negative relationship 
between leverage ratios and bank insolvency,'' but ``no such 
evidence between risk-based capital ratios and bank 
insolvency.'' Do you agree with Dr. Kaufman? If so, does this 
conclusion undermine the Basel II framework?

A.5. Dr. Kaufman is correct that there is ``substantial 
empirical evidence'' that banks with low leverage ratios are 
more likely to fail. There also is some academic evidence that 
banks with low risk-based capital ratios are more likely to 
fail, and some research at the FDIC has verified this result. 
However, it should be noted that most bank failures occurred 
before risk-based capital standards were implemented.

Q.6. Have you undertaken any analysis of the initial start-up 
costs and annual compliance costs that Basel II will impose on 
banks?

A.6. FDIC staff conducts routine outreach with regulated 
institutions that might be subject to Basel II. Cost estimates 
associated with designing and implementing systems and 
recruiting, training, or reallocating personnel are across the 
spectrum and are by no means firm at this juncture.

Q.7. To what degree will the significant costs necessary to 
comply with Basel II act as a barrier to entry that prevent 
banks from growing and becoming a bank large enough to qualify 
to use Basel II? In effect, will Basel II cement the market 
positions of the largest banks? If no, why?

A.7. The FDIC believes that the costs of implementing a 
qualified Basel II capital system would act as a significant 
barrier to adoption of the new framework for many institutions. 
In order to use the advanced internal risk-based approaches of 
Basel II, expensive data management systems and complex 
modeling must be employed; the cost of such systems would be 
too great for smaller and medium-sized banks to afford. The 
recently proposed modifications to the domestic risk-based 
capital rules attempt to partially mitigate this effect and 
even the playing field between Basel II and non-Basel II banks 
in the United States by establishing a more risk sensitive 
framework based on risk measures more suited to the operations 
of community banks.

Q.8. Please explain the type of information that banks will be 
required to disclose under Pillar 3 with respect to how banks 
calculate their capital requirements? Will banks be required to 
disclose proprietary capital requirement models?

A.8. The risks to which a bank is exposed and the techniques 
that it uses to identify, measure, monitor, and control those 
risks are important factors that market participants consider 
in their assessment of the institution. In addition to 
reporting their capital ratios and minimum capital 
requirements, the agencies expect banks to disclose information 
that includes the weighted average estimated probability of 
default, loss given default, exposure at default, and expected 
loss for each category of wholesale and retail exposures. The 
agencies also will request information on credit risk mitigants 
and off-balance-sheet exposures.
    The Pillar 3 disclosure requirements as summarized above 
provide for an appropriate balance between the need for 
meaningful disclosure and the protection of proprietary and 
confidential information. Accordingly, the disclosure 
requirements have been structured in a manner that should limit 
the extent to which proprietary and confidential information is 
revealed. The agencies have solicited comments on the 
disclosure requirements though the Basel II ANPR process as 
well as through the issuance of Basel consultative papers. 
There is a need to strike a balance between obtaining 
sufficient information disclosure and protecting proprietary 
information and the agencies will carefully consider comments 
received on these issues. In addition, the agencies have 
previously sought input on the disclosure requirements through 
meetings with banks, ratings agencies, and other groups in 
connection with our participation on the Basel Committee's 
Transparency Group.

Q.9. If Basel II is implemented, do you favor at any point in 
the future reducing the leverage ratio for well-capitalized and 
adequately capitalized banks or reducing the statutory capital 
thresholds for prompt corrective actions?

A.9. No. The Basel II minimum capital measure fails to provide 
for any protection against interest rate risk, liquidity risk, 
and other material risks present in our banking system. Credit 
risk, market risk, and operational risk are modeled under Basel 
II, but such modeling is subject to a great deal of 
uncertainty. Given the existence of deposit insurance and other 
Federal bank safety net supports, clear constraints are needed 
on the proportion of a bank's 
activities that can be financed with debt.
    The FDIC believes that the leverage ratio and the risk-
based capital ratios are complementary measures that work well 
together, each compensating for the other's shortcomings. The 
leverage ratio sets the minimum amount of qualifying equity at 
stake in the financial institution. The risk-based capital 
ratio operates to establish limits on the amount of credit risk 
that a financial institution can undertake. Even in a situation 
where the risk undertaken by an institution is very low, moral 
hazard can still occur if the amount that the equity holders 
have at risk is insufficient. Hence from the perspective of an 
insurer, the leverage ratio plays a predominant role in 
constraining moral hazard.

Q.10. In his testimony, Mr. Isaac points out that compared to 
European banks, ``large U.S. banks are much better capitalized 
and far more profitable in terms of their operating margins.'' 
Do you agree or disagree with Mr. Isaac's observation, and what 
is your rationale for your position?

A.10. The FDIC agrees with Mr. Isaac's observation. Data 
presented by The Banker magazine in their annual review of the 
``Top 1000 World Banks'' as well as data that are presented by 
Fitch Rating's international bank database, ``Bankscope,'' 
generally indicate that large U.S. banks are better capitalized 
and have higher operating margins than many of their European 
counterparts.

Q.11. Do you believe that U.S. banks are operating at a 
significant competitive disadvantage vis-a-vis foreign banks 
due to the higher capital requirement imposed on U.S. banks? If 
you do, please explain in detail and quantify the competitive 
effects on U.S. banks, including giving your assessment of how 
low U.S. capital requirements would need to go in order to 
level the playing field with large foreign banks.

A.11. No. Given the many differences in the global financial 
system, such as tax, accounting, and legal frameworks, it is 
difficult to isolate the effects of regulatory capital 
requirements on international bank competition. This difficulty 
is compounded by the fact that the definition of which items 
constitute capital differs in each country to a greater or 
lesser degree. It is clear, however, as the question suggests, 
that U.S. banks face higher capital requirements than foreign 
banks face because of U.S. Prompt Corrective Action regulations 
(and because of a series of U.S. regulatory tightenings of the 
Basel I risk-based capital standards not emulated overseas). 
Yet, as indicated in the answers to other questions, this does 
not appear to have compromised U.S. banks' ability to prosper 
and compete effectively.

Q.12. If capital standards are reduced for the largest U.S. 
banks, do you believe that will place U.S. banks that do not 
implement Basel II at a competitive disadvantage vis-a-vis 
banks that do implement Basel II? If so, how would you suggest 
that competitive inequity be remedied?

A.12. Because the United States historically has maintained 
regulatory capital standards that have been, for the most part, 
the same for all banks, there is no historical evidence on 
which to base judgments about the competitive effects of 
applying vastly different regulatory capital regimes to 
different banks.
    Our judgment is that Basel II could place community banks 
and thrifts at a competitive disadvantage vis-a-vis Basel II 
banks in the United States since the A-IRB approach available 
under Basel II would likely yield lower capital charges on many 
types of products offered, such as residential mortgage loans, 
retail loans, commercial loans, and commercial real-estate 
loans as reported in QIS-4. Without a change in the risk-based 
capital requirements imposed upon non-Basel II adopters, Basel 
II would appear to open up sizable gaps between the capital 
requirements of small and large banks for many activities. The 
potential exists that investors in small banks would receive 
suboptimal returns on these capital-disadvantaged assets 
compared to the returns that owners of large banks could earn 
on the same assets, resulting in a disequilibrium that would be 
corrected over time by the movement of those assets toward the 
large banks.
    The ANPR was published in October to make capital 
requirements for the remaining 8,000 banks in the industry more 
risk sensitive. If this Basel I-A initiative ultimately proves 
to offer only modest capital reductions to most banks, and if 
Basel II proves to be as substantial a reduction in risk-based 
capital requirements as the QIS-4 results suggest, bank 
regulators will be faced with difficult decisions with regard 
to regulatory capital. The FDIC has 
expressed a preference in Congressional testimonies (May and 
November 2005) that these issues ultimately be resolved by 
finding ways to achieve less extreme results under Basel II, 
including recalibration of underlying formulas if results 
similar to QIS-4 persist during the parallel run and transition 
period.

Q.13. Have you considered requiring the largest U.S. banks to 
implement Basel II-type models as part of their risk management 
programs without making Basel II a capital-regulation device? 
If you have considered and rejected such an approach, please 
explain why you rejected it.

A.13. A number of large U.S. institutions currently employ 
internal economic capital allocation models to manage risk and 
make business line decisions, and have for some time. The 
regulators believe that banks' use of such models--the 
information they generate and the processes and internal 
controls around their validation--are of value to supervisors. 
Regulators' use of these approaches could take two 
fundamentally different directions. One is to base an explicit 
system of minimum capital requirements on these approaches. The 
other would be to retain the simpler existing capital 
requirements while making the validation of risk-measurement 
information generated by models a supervisory or ``Pillar 2'' 
requirement. Both approaches are conceptually defensible and, 
we believe, either can be made to work.

Q.14. Have you compared the capital requirements for the 
participating banks that came out of your Quantitative Impact 
Study with the judgments of your professional bank examination 
staff on the capital needs of those same banks? How closely 
correlated were the results?

A.14. FDIC examination staff was very much involved in 
designing, planning, and implementing QIS-4 and in analyzing 
the results. The FDIC remains concerned with the capital levels 
and the dispersion of results in QIS-4 data. Minimum tier 1 
capital requirements reported by most of the 26 organizations 
were not at levels the FDIC would regard as consistent with 
safe and sound banking were banks actually to operate at such 
levels under an up-and-running system of capital regulation. 
QIS-4 results also reflected substantial dispersion of capital 
requirements for what appeared to be identical risks. Our 
expectation is that meaningful work remains to be done during 
the parallel run and transition years to address these issues.

Q.15. Basel II represents an attempt to apply the same formulas 
for measuring commercial loan credit, consumer loans, and 
commercial real estate loan risk to banks in the United States 
and to banks in other developed countries. What evidence do you 
have that the formulas will assure that U.S. banks will hold 
sufficient capital to see them through a variety of economic 
scenarios, such as those that have occurred in the United 
States over the last 25 or 50 years? Are the markets and 
economic environments similar enough that the same formulas can 
be applied safely to large banks from the United States, 
Canada, the United Kingdom, France, Germany, Japan, etc.?

A.15. If we were faced with the prospect of sole reliance on 
Basel II as it now exists, without benefit of the leverage 
ratio, we would not have confidence that the formulas would 
require enough capital to see banks through a variety of 
scenarios. The preservation of the leverage ratio and the 
additional work that will be done during the Basel II 
transition years will be crucial, in our judgment, to ensuring 
the success of this framework.
    With regard to cross-country comparisons, it should be 
noted that Basel II is not a treaty, and each country will 
implement the framework in its own way that makes sense given 
the various legal, tax, and accounting frameworks, and other 
differences. Also, while it may be technically correct that 
``the same formula'' determines capital requirements across 
countries, its implementation leaves much up to the discretion 
of supervisors. It is a premise of the Basel II initiative that 
the supervisors will ensure adequate capital in each instance.

Q.16. The agencies' current transitional plan for implementing 
Basel II contemplates allowing capital levels to fall to an 85 
percent ``floor.'' How can the agencies know, even before the 
``parallel run'' contemplated for 2008, that a drop of 15 
percent in the capital of banks would be consistent with safety 
and soundness considerations?

A.16. The agencies' have stated the expectations, as described 
above, that Basel II might result in a modest overall aggregate 
reduction in capital requirements, with the impact on capital 
requirements at individual banks depending on risk profiles. We 
are not aware of any expectation that risk-based capital 
requirements will fall 15 percent or more in aggregate, and do 
not believe such a decline would be acceptable. The agencies 
have not ruled out a 15 percent reduction in risk-based capital 
requirements for individual banks if warranted by their risk 
profiles.
    In this regard, it should be noted that the agencies have 
stated that the declines in capital requirements reported in 
QIS-4 are unacceptable, and if similar results persist 
throughout the transitional implementation period, further 
measures would be taken to remedy such declines.

Q.17. Basel II's capital formulas are based on highly complex 
models that are to be implemented on a bank specific basis. 
While Basel I has been criticized for its over simplification, 
the sheer complexity of Basel II has raised some very serious 
concerns. In his written testimony, Mr. Isaac states, ``Basel 
II is so complex it cannot be adequately understood by senior 
bank managements, boards of directors, regulatory, or the 
public.'' Professor Kaufman states, ``Increased complexity is 
likely, however, to both increase compliance cost and reduce 
understanding, particularly by the bank CEO, board of 
directors, and possibly even the CFO and by bank supervisors.'' 
Do you share Mr. Isaac's and Professor Kaufman's concerns? If 
you share their concerns, what recommendations do you have for 
the regulators as to how to fix this problem?

A.17. The FDIC shares these concerns. Given its ambition to 
measure all forms of credit risk, operational risk, and market 
risk, the Basel II framework is, inevitably, complex. It is 
likely that there will be few individuals who will read and 
understand, in its entirety, the U.S. Notice of Proposed 
Rulemaking implementing Basel II. As discussed below, some of 
the adverse effects of this complexity may be mitigated through 
appropriate written supervisory guidance, through the retention 
of the leverage ratio requirements of U.S. Prompt Corrective 
Action regulations, and through a transparent approach to 
implementation of the framework.
    First, supervisory guidance will be important in helping 
banks cut through some of this complexity--and supervisory 
guidance will follow the publication of any NPR.
    Second, the leverage-ratio capital requirement that is part 
of the agencies' Prompt Corrective Action regulations will 
ensure that the need for a clear-cut minimum of regulatory 
capital is not lost in the complexity of Basel II. Basel II is 
a formula-driven regime that produces a capital requirement 
that some may portray as having the mantle of science. There is 
a danger that the complexity of this framework may obscure the 
reality that representations of its scientific certainty are 
incorrect.
    Finally, a transparent approach to the implementation of 
Basel II may help mitigate the adverse effects of complexity. 
That means public dissemination of the results of risk-based 
capital calculations and summary views of the inputs to those 
calculations. It means sharing of supporting confidential 
detail behind the capital calculations among the agencies to 
promote consistency and best practices. It may ultimately, 
perhaps, involve some way for regulators to share with the 
industry some type of information about approaches that are 
being taken under the framework to the measurement of risk.

Q.18. According to FDIC data, the equity to capital ratio of 
insured U.S. financial institutions reached a low of slightly 
above 5 percent in the late 1980's, during the S&L crisis, and 
then rose steadily through the 1990's reaching the level of 
over 10 percent, at which it stands today. Profits--as measured 
by return on assets--which had fallen dramatically during the 
period of low capital, also began a steady rise in the 1990's, 
rising to well over 1 percent for the last decade, reaching 
record levels. When looked at together, it becomes clear that 
large profits and strong levels of capital can coexist. Do you 
agree that strong levels of bank capital can and do coexist 
with strong bank profitability?

A.18. As indicated in the answers to questions 2, 10, and 11, 
the FDIC agrees that strong levels of bank capital can and do 
coexist with strong bank profitability.

Q.19. Under the Administrative Procedure Act, agencies are 
required to consider public comment prior to issuing new final 
regulations. How can the agencies fully comply with this 
requirement? Doesn't the fact that the agencies reached an 
international agreement on the new capital framework 
effectively limit their ability to fully consider public 
comment and modify proposed regulations in light of that 
comment?

A.19. The Basel Committee is not a standard setting body but a 
committee of technical experts that makes recommendations from 
time to time about best practices. Individual countries 
consider these recommendations and may elect to act on them, or 
not, as appropriate. The U.S. agencies have made clear 
repeatedly at the Basel Committee the seriousness with which 
they take the notice and comment process in the United States.
    The FDIC is committed both to fully consider all comments 
and to take action to address those comments as appropriate.

Q.20. The Basel II framework ignores a significant risk: 
Interest rate risk. Many banking assets, such as mortgage 
servicing rights, are extremely sensitive to changes in 
interest rates, and the value of assets such as these may 
fluctuate dramatically when interest rates change. How do you 
propose to take interest rate risk into account under the Basel 
II framework?

A.20. The FDIC, the Federal Reserve, and the OCC historically 
have not promulgated explicit capital regulations to cover the 
interest rate risk of banks' exposures held outside of trading 
accounts. This tradition continues with Basel II.
    The Basel II framework establishes a ``three-pillar'' 
approach to bank capital regulation. Pillar 1 sets the 
standards for computing regulatory capital requirements, 
consisting of credit, market, and operational risk. Pillar 2 is 
a supervisory review process that examines factors not 
considered under Pillar I, such as board oversight, internal 
controls, and assessment of risk to ensure capital adequacy. As 
noted earlier, Pillar 3 encourages market discipline through a 
public disclosure process.
    Interest rate risk is not captured in the minimum 
requirement calculation set forth in Pillar 1. Rather, 
supervisors plan to incorporate interest rate risk, and other 
risks such as liquidity and 
concentration risks, within the ``assessment of risk for 
capital adequacy'' process under Pillar 2. The FDIC is aware of 
the importance of interest rate risk when assessing the 
appropriate level of capital to an institution and directs its 
examiners to consider this risk in relation to capital 
adequacy. In fact, the ``S'' component of the CAMELS rating, 
which measures sensitivity to market risk, specifically takes 
into consideration a bank's interest rate risk.

Q.21. Due to the tremendous devastation caused by Hurricanes 
Katrina and Wilma this fall, it is estimated that over 100,000 
homes have been lost. Would the Basel II framework have 
provided institutions with enough capital buffer to handle a 
calamity of this magnitude?

A.21. The current well-capitalized position of U.S. banks was a 
strength of the local banks impacted by the hurricane. It is 
our intention that Basel II not result in a significant decline 
in capital that would place U.S. banks in a position to cope 
less effectively with unforeseen circumstances.
    With respect to mortgages, it must be noted that the QIS-4 
reported extraordinarily large reductions in regulatory capital 
requirements. Without some type of clarification or regulatory 
refinement during the transition years, our concern is that 
Basel II will prove to undercapitalize substantially the risk 
inherent in mortgage portfolios.

Q.22. Last week, on November 18, 2005 The Financial Times 
published an editorial by Harold Benink and Jon Danielsson 
titled, ``There is a chance to correct the defects of Basel 
II.'' Harold Benink is Professor of Finance at RSM Erasmus 
University in the Netherlands. Jon Danielsson is Reader in 
Finance at the London School of Economics. They concluded: 
``Instead of requiring bank capital to be risk sensitive, 
banking regulation should simply require the use of high 
quality risk models in banks without using their output to 
determine capital. Minimum capital is better calculated as a 
simple fraction of bank activity in broad categories.'' What is 
your response to this suggestion?

A.22. As indicated in the answer to question 13 above, relying 
on simpler measures of capital adequacy for regulatory purposes 
while using the supervisory process to promote the rigorous use 
of banks' internal capital models would be an alternative, and 
defensible, way for the agencies' supervisory programs to 
benefit from banks' use of internal models.
    As we noted in response to question 9, the FDIC believes 
that both the leverage ratio (``the simple fraction of bank 
activity in broad categories'' referenced above) and the risk-
based capital ratios have important roles to play in ensuring 
safe and sound banking.

Q.23. In his testimony, Mr. Isaac states, ``I have not found a 
single professional hank supervisor who is enthusiastic about 
Basel II.'' We have also heard of a similar lack of enthusiasm 
on the part of the supervisors who will actually be responsible 
for supervising Basel II. What is your response? Separately, 
what gives you confidence that regulators will be up to the 
task of understanding and policing Basel II?

A.23. As indicated in responses to previous questions, the FDIC 
has serious concerns about the impact on capital under Basel II 
as evidenced in the QIS-4 results. The FDIC, along with the 
other regulators, believes these results were unacceptable and 
must be addressed if Basel II implementation is to proceed.
    Supervisors at the FDIC are committing significant 
resources to policy development and implementation strategies 
for Basel II. This includes collaboration with key FDIC 
research staff. The FDIC staff involved in this effort bring a 
level of engagement and professionalism to this task that gives 
the agency confidence that it will be up to the task of 
implementing the new framework while acknowledging the 
challenges that will be posed.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY 
                       FROM JOHN M. REICH

Q.1.a. Basel II would impose new demands on bank regulators. It 
would require bank regulators to not only approve banks' 
internal assessments of their risks, but also to make judgments 
on whether banks are holding enough capital in light of all the 
risks banks face. This means bank regulators are going to need 
personnel who are well-trained in risk analysis.
    How many additional personnel does your agency expect it 
will need to hire in order to implement Basel II? What type of 
expertise will your agency need to obtain? Do you foresee any 
problems in recruiting?

A.1.a. OTS anticipates that it will need more examiners, 
quantitative experts, and other supervisory personnel with 
expertise in the support areas of finance, economics, 
accounting, and law. Although OTS cannot predict how the Basel 
II proposal may change as a result of the notice and rulemaking 
process, under the current draft of the Basel II NPR, OTS would 
be the primary Federal 
supervisor of one core banking organization, several that have 
indicated a desire to opt-in, and several subsidiaries of Basel 
II organizations, holding companies, or broker-dealers. While 
hiring has 
already begun, OTS is prepared to expand its staff of trained 
professionals throughout the period leading to the full 
implementation anticipated in 2012.
    OTS believes it can meet the challenge with a combination 
of training programs and external staff recruitments. While the 
recruitment environment is and will continue to be competitive 
for such professionals, OTS has already demonstrated recruiting 
success, at both entry and senior levels, and we are confident 
we will continue to do so. OTS has begun and will continue to 
enhance both internal and external training for many of our 
current staff at all levels, in order to ``retrofit'' our 
current resources to the work of ensuring safety and soundness 
under capital rules as they are revised.

Q.1.b. Will your agencies be able to successfully compete 
against banks in the recruitment of personnel? Do you have any 
concerns that banks will simply be able to hire the best 
Ph.D.'s in risk modeling and outgun their regulators?

A.1.b. As stated in the answer to Question 1.a., OTS believes 
it will successfully meet its hiring needs in a competitive 
environment, and has already recruited talented professionals 
at many levels. OTS offers a stimulating work environment, and 
a competitive compensation package that includes excellent 
benefits and quality-of-life considerations when compared to 
the private sector. This should help OTS attract and retain 
additional staff in the necessary disciplines.

Q.1.c. How much in additional annual costs do you expect to 
incur in implementing Basel II? Other than personnel costs, 
what other costs will your agency incur in implementing Basel 
II? Are there any large one-time costs?

A.1.c. OTS estimates that it has incurred costs of nearly $4 
million from fiscal year 2002 through fiscal year 2005 related 
to the development and implementation of the new Basel II 
Accord and proposed NPR. For fiscal year 2005 alone, the cost 
approached $2 
million, or between 1 percent and 2 percent of the OTS budget. 
While some part of the start-up costs may be characterized as a 
one-time investment, the annual expenditure, thus far, has 
increased each year. OTS anticipates that the annual cost 
should decline as the revised framework is established and the 
agency begins to reap economies of scale in building expertise 
around that framework.
    In general, costs fall in four areas:

 Training. Development of internal training, as well as 
    attendance at external training sessions.
 Travel. Both prequalification and qualification 
    meetings will require travel, as will national and 
    international regulatory meetings, on-site examinations, 
    and other supervisory activities.
 Data systems. Development of data systems to handle 
    new reporting requirements.
 Administrative. Rulemaking, guidance development, and 
    industry outreach.

Q.2.a. In his testimony, Dr. Tarullo posed several questions 
that he believes need to be answered by U.S. banking agencies 
before implementation of Basel II begins. Please provide 
answers to his questions with respect to your agency, which are 
as follows:
    ``Do the agencies believe that, in general, minimum capital 
levels are too high and if, so, what is the basis for this 
belief ?

A.2.a. OTS does not believe that minimum capital levels are too 
high. However, OTS believes that the current capital rules, 
which involve a relatively simple risk-bucketing system, are 
limited as tools for measuring risks of sophisticated and 
complex financial activities.

Q.2.b. Have the agencies been able to predict with reasonable 
precision the levels of capital that the A-IRB approach will 
require of large banks, and then to confirm their prediction 
though studies that are well-conceived and executed?

A.2.b. QIS-4 was conducted on a best efforts basis. There were 
data quality issues that reflected institutions' various stages 
of development of their models and systems. In addition, the 
rulemaking and implementation processes were also in the early 
states such that the QIS-4 was done without institutions having 
a clear understanding of what the Basel II systems requirements 
and supervisory expectations would be.
    OTS participated in QIS-4, which facilitated policy 
analysis regarding appropriate capital levels, and provided 
information for peer group capital comparisons between the core 
institutions. The QIS-4 results helped the agencies to better 
understand the impact of a more risk-sensitive approach for 
regulatory capital standards. This effort enabled the agencies 
to better gauge appropriate capital levels at banking 
organizations, but there are diverging views on the levels of 
capital that the A-IRB approach will ultimately require. 
Moreover, all aspects of the Basel II NPR will be subject to 
change as a part of the notice and comment rulemaking process, 
which may also impact the capital levels that are ultimately 
required. The agencies anticipate more studies in the 
intervening 6 years before a Basel II final rule is expected to 
be fully implemented in the United States.

Q.2.c. Have the agencies done scenario planning to anticipate 
the effects, unintended and otherwise, of Basel II upon the 
financial system as a whole? For example, are significant 
portions of certain kinds of assets likely to migrate out of 
banks into the unregulated sector? If so, might new risks of 
financial disruption be created?

A.2.c. In the latest draft of the Basel II NPR, implementation 
would not occur until after a parallel run, which is projected 
to be in 2008. The parallel run would take place the first year 
after the final rule's effective date. After that time period, 
there would be 3 years of floor capital levels imposed--95 
percent of the Basel I-based capital requirement the first 
year, 90 percent in the second year, and 85 percent in the last 
year. Of course, the parallel run, floor periods, and floor 
capital levels may ultimately change as a result of public 
comment on the Basel II NPR. However, it would be under these 
periods of time that scenario planning would take place.
    Until full implementation, it is too attenuated to 
anticipate the potential consequences of Basel II 
implementation, intended or unintended. As stated previously, 
however, the agencies are committed to ongoing refinement 
throughout the process, including after implementation, as 
necessary, and would make changes if such scenario planning 
demonstrates changes are warranted.

Q.2.d. What do the agencies regard as the effective capacity of 
the specialized examiner teams that will be overseeing the use 
of bank models under A-IRB? How will the agencies determine 
whether other countries are successfully monitoring bank 
capital levels under the A-IRB approach?

A.2.d. OTS has experience in overseeing the use of models and 
validation processes. In anticipation of the proposed new 
capital framework, OTS is already developing specialized 
examination teams with the training necessary to oversee the 
use of A-IRB. The Basel II Accord is an international agreement 
with a multilateral commitment that each country will supervise 
the measurement and management of capital within its own 
financial institutions. International consultative processes 
have been ongoing throughout the development of Basel II to aid 
that goal. Theses will, no doubt, continue.

Q.2.e. Have the banking agencies consulted with institutional 
investors, rating agencies, independent analysts, and other 
market actors concerning the amount of information about their 
credit modeling that A-IRB banks will be required to disclose? 
[If so, what were the views of these market actors as to the 
adequacy of the contemplated disclosure requirements?]

A.2.e. The Pillar 3 disclosures have been issued for public 
comment, both formally and informally, on a number of 
occasions, and will be subject to further public comment 
following the issuance of the Basel II NPR. In addition, 
representatives of the Federal banking agencies consulted with 
market participants in developing the disclosures. In general, 
market participants, such as debt and equity analysts, have 
supported enhanced public disclosures of risk information and 
capital adequacy by banking organizations. The version of 
Pillar 3 included in the June 2004 text from the BIS balances 
the desire for additional disclosures by market participants 
and the reporting burden associated with such disclosures. This 
version leverages off of the information institutions will need 
in order to implement Basel II, and is substantially 
streamlined from earlier Pillar 3 proposals.

Q.2.f. Do the banking agencies continue active study of 
alternative approaches to capital regulation, such as the 
varieties of proposals based on market discipline or on so-
called precommitment?''

A.2.f. The agencies have studied the other approaches and have 
determined that the direction we are moving in, and that will 
be enunciated more fully in the upcoming Basel II NPR and 
guidance, is the best approach available. However, we also are 
committed to flexibility and will consider all new ideas, 
including new approaches and refinements suggested by public 
commenters on the Basel II NPR. We understand that none of us 
can predict what may evolve over the next half-decade for 
incorporation into the Basel II rules in the United States. And 
we have said consistently, this will be an iterative process, 
even after we have ``finalized'' the Basel II rules. We are 
prepared to introduce, for comment, any changes that serve 
safety and soundness.

Q.3. Although Basel IA aims to reduce any competitive advantage 
Basel II may confer on large banks, have you conducted any 
analysis to determine whether Basel I-A itself creates any 
competitive issues within the subset of banks that are intended 
to be covered by it? If not, do you intend to do so?

A.3. When the agencies issued the Basel I-A ANPR, we recognized 
the competitive issues between large banking organizations, 
small community institutions, and regional banking 
organizations. We specifically invited and anticipate comments 
on competitive issues among and between all kinds of charters 
and different institutions, by size and specialty. Since the 
Basel I-A ANPR does not propose specific capital requirements, 
it is probably premature to do an impact analysis at this time, 
but we will analyze the capital impact of the approaches in the 
Basel I-A NPR after these approaches are formulated. OTS senior 
economists and examiners will also continue their analysis of 
the models-based approaches in the Basel II NPR, and will 
analyze the approaches adopted in the Basel II Final Rule, with 
a careful eye on competitive concerns.

Q.4. What consideration has been given to the fact that there 
are huge differences between 7,000 or so banks that will 
participate in the Basel I-A framework?

A.4. OTS recognizes that a broad-based capital rule will not 
address the idiosyncrasies of all 7,000 community banks and 
thrifts. However, the Basel I-A rulemaking will likely benefit 
financial institutions that have sound risk management systems 
in place, and we expect it will also benefit smaller community 
institutions that are less sophisticated. One of the primary 
goals of the Basel I-A rulemaking is to better align capital 
commensurate with risk. The Basel I-A ANPR suggested changes 
attempt to meet this goal without undue burden to community 
banks and thrifts. These improvements would be available to all 
and are designed to benefit all by better aligning risk with 
capital. However, in further recognition of the difference 
among institutions, the Basel I-A ANPR specifically asked for 
comment on allowing institutions the flexibility to remain 
under the simpler and well-established Basel I-based rules, 
which in most instances would result in those institutions 
holding greater risk-based capital. OTS will carefully evaluate 
the comments received when we develop the Basel I-A NPR.

Q.5. In Dr. Kaufman's testimony, he stated that there is 
``substantial empirical evidence of a negative relationship 
between leverage ratios and bank insolvency,'' but ``no such 
evidence between risked-based capital ratios and bank 
insolvency.'' Do you agree with Dr. Kaufman? If so, does this 
conclusion undermine the Basel II framework?

A.5. We partially agree with Dr. Kaufman's analysis that the 
current risk-based capital system is insufficiently risk-
sensitive. While eliminating a leverage ratio is not a viable 
option at this time, this observation supports our efforts in 
implementing a more risk sensitive regime, rather than 
undermining it.

Q.6. Have you undertaken any analysis of the initial start-up 
costs and annual compliance costs that Basel II will impose on 
banks?

A.6. As part of the regulatory impact study required for the 
Basel II NPR, OTS continues to analyze such costs. Thus far, 
only anecdotal information using a variety of metrics is 
available regarding start-up costs. Compliance costs will be 
assessed in future estimates.

Q.7. To what degree will the significant costs necessary to 
comply with Basel II act as a barrier to entry that prevent 
banks from growing and becoming a bank large enough to qualify 
to use Basel II? In effect, will Basel II cement the market 
positions of the largest banks? If not, why?

A.7. OTS does not believe that cost will create a significant 
barrier to future growth for thrifts. Because the Basel II NPR 
is designed to reflect sound risk management practices for the 
largest and most complex financial institutions, these 
institutions have already incurred costs to develop 
sophisticated risk management practices and systems. However, 
we expect significant additional cost at some institutions to 
modify existing information systems, policies, and procedures 
to meet the requirements that may be contained in the Basel II 
final rule, as well as to train or hire staff. As other thrifts 
grow and engage in more complex activities, OTS expects these 
institutions to also incur costs to develop more risk sensitive 
management practices and systems. We expect there would be 
marginal additional expense associated with compliance with the 
Basel II final rule beyond what was spent to develop such 
systems.
    From an international perspective, the largest foreign 
banks already have systems and practices in place, and are 
competing with U.S. financial institutions, large and small, in 
every corner of the financial industry, including the wholesale 
and retail business. OTS believes that our largest thrifts will 
find it necessary to improve their risk management practices 
for competitive reasons, regardless of a Basel II final rule.

Q.8. Please explain the type of information that banks will be 
required to disclose under Pillar 3 with respect to how banks 
calculate their capital requirements? Will banks be required to 
disclose proprietary capital requirement models?

A.8. Consistent with Pillar 3 requirements discussed in the 
Mid-Year Text, the agencies intend to propose to collect, both 
qualitatively and quantitatively, the following disclosures: 
Scope of 
Application; Capital Structure; Capital Adequacy; Credit Risk, 
Credit Risk Mitigation, Securitization Approaches; Market Risk, 
Operational Risk, Equities, and Interest Rate Risk. The 
proposed disclosure requirements would be structured to limit 
the extent of public disclosure of confidential and proprietary 
information. In addition, the agencies will request comments 
from institutions and other interested persons on the 
appropriateness of the proposed disclosure requirements in 
connection with the Basel II NPR.

Q.9. If Basel II is implemented, do you favor at any point in 
the future reducing the leverage ratio for well-capitalized and 
adequately capitalized banks or reducing the statutory capital 
thresholds for prompt correction actions?

A.9. At this time, OTS opposes elimination of the leverage 
ratio, and we urge great caution in any consideration to lower 
it. We do, however, believe it is imperative that we engage in 
a dialogue with the financial industry and other stakeholders 
to rethink what a leverage ratio should be, as we make these 
major changes in risk-based capital standards. We believe the 
agencies should, as part of the eventual adoption of changes to 
risk-based capital in the Basel II and Basel I-A rulemakings, 
consider how best to synthesize a leverage ratio with these new 
standards, especially as we become more comfortable with the 
safety and soundness of the new rules in the years to come. We 
oppose reducing the statutory capital thresholds for prompt 
corrective action.

Q.10. In his testimony, Mr. Isaac points out that compared to 
European banks, ``large U.S. banks are much better capitalized 
and far more profitable in terms of their operating margins.'' 
Do you agree or disagree with Mr. Isaac's observation, and what 
is your rationale for your position?

A.10. OTS agrees with the observation, and further adds that 
the U.S. markets have experienced favorable credit conditions 
over the last several years. Many foreign banks have been 
attracted to the U.S. market for that reason. Only the United 
Kingdom has neared the United States in terms of economic 
growth among major competitors. The changes in the current 
draft of the Basel II NPR would bring oversight and capital 
measurement between Europe and the United States into better 
alignment, which may level the playing field for U.S. banking 
organizations with their foreign competitors here.

Q.11. Do you believe that U.S. banks are operating at a 
significant competitive disadvantage vis-a-vis foreign banks 
due to the higher capital requirements imposed on U.S. banks? 
If you do, please explain in detail and quantify the 
competitive effects on U.S. banks, including giving your 
assessment of how low U.S. capital requirements would need to 
go in order to level the playing field with large foreign 
banks.

A.11. Merely lowering capital is not the key to 
competitiveness. Competitiveness is enhanced by improvements to 
management and measurement of risks within a capital system. 
The system should adequately reflect risks so that capital 
requirements themselves do not prevent U.S. banking 
organizations from competing in various markets, here and 
abroad.

Q.12. If capital standards are reduced for the largest U.S. 
banks, do you believe that will place U.S. banks that do not 
implement Basel II at a competitive disadvantage vis-a-vis 
banks that implement Basel II? If so, how would you suggest 
that competitive inequity be remedied?

A.12. In an effort to alleviate disadvantages that smaller 
institutions may experience, the agencies are pursuing rule 
changes in the Basel I-A rulemaking. Modernizing risk-based 
capital is necessary, through the Basel I-A and the Basel II 
rulemakings, for all U.S. banking organizations. Through the 
notice and comment periods, the banking agencies will address 
any competitive inequities.

Q.13. Have you considered requiring the largest U.S. banks to 
implement Basel II-type models as part of their risk management 
programs without making Basel II a capital-regulation device? 
If you have considered and rejected such an approach, please 
explain why you rejected it?

A.13. Although considered, OTS believes that risk management 
programs and capital requirements are mutually reinforcing 
concepts. Thus, allowing appropriate adjustments for capital 
based on these enhanced programs is more likely to provide the 
needed incentive to cause institutions to move toward more risk 
sensitive management behaviors. OTS believes we can promote 
both safe and sound risk management systems and adequate 
capital levels, which will allow thrifts to successfully 
compete in the inter-connected global markets.

Q.14. Have you compared the capital requirements for the 
participating banks that came out of your Quantitative Impact 
Study with the judgments of your professional bank examination 
staff on the capital needs of those same banks? How closely 
correlated were the results?

A.14. OTS examination staff was involved in the planning and 
implementation of QIS-4, and agreed that, upon review of the 
results, there was a fair amount of dispersion caused by 
differences in data and methodologies across participating 
institutions. OTS expects to engage examination staff in the 
additional work that will be done during the transition years 
to address these issues.
    QIS-4 was a best efforts exercise. Nevertheless, the 
results informed us about changes, enhancements, 
clarifications, and significant adjustments the agencies need 
to make to the framework to better align capital with risk as 
we move forward.
    QIS-4 focused on the Pillar 1 capital calculation, which 
consists of capital allocated to credit risk and operational 
risk. It did not include an assessment of overall capital 
adequacy under Pillar 2. In order to make a supervisory 
assessment regarding the adequacy of capital compared to the 
comprehensive risk profile of an institution, it would be 
necessary to include both Pillar 1 and Pillar 2 capital. Thus, 
it would have been inappropriate to compare QIS-4 
results to the total capital that a financial institution is 
expected to retain. A judgmental assessment of capital 
requirements calculated under the QIS-4 exercise can only be 
performed based on a review of credit risk separate from other 
risks associated with the lending operations. Subject to that 
premise, we found that, for most portfolios, the calculation 
for the credit risk component of the lending operation that is 
in the current draft of the Basel II NPR was consistent with 
the perceived risk based on supervisor and examination 
experience.

Q.15. Basel II represents an attempt to apply the same formulas 
for measuring commercial loan credit, consumer loans, and 
commercial real estate loan risk to banks in the United States 
and to banks in other developed countries. What evidence do you 
have that the formulas will assure that U.S. banks will hold 
sufficient capital to see them through a variety of economic 
scenarios, such as those that have occurred in the United 
States over the last 30 or 50 years? Are the markets and 
economic environments similar enough that the same formulas can 
be applied safely to large banks from the United States, 
Canada, the United Kingdom, France, German, Japan, etc.?

A.15. The agencies expect that banking organizations will 
manage their regulatory capital positions so that they remain 
at least adequately capitalized during all phases of the 
economic cycle, including economic downturns. The current draft 
of the Basel II NPR would require a banking organization to 
segment retail portfolios by similar risk characterizations, 
and group commercial loans by internal ratings categories. The 
past performance of the retail loan segment or commercial loan-
rating category would be determined through review and analysis 
of internal or external data, and the banking organization 
would produce an estimate of the economic loss expected if the 
obligor were to default during economic downturn conditions. 
The formulas would incorporate economic downturn conditions in 
terms of the aggregate default rates for the exposure's 
supervisory asset class in the exposure's supervisory 
jurisdiction (United States or another developed country). 
Accordingly, the proposal would require banking organizations 
to use a loss given default (LGD) estimate that reflects 
economic downturn conditions for purposes of calculating the 
risk-based capital requirements.

Q.16. The agencies' current transitional plan for implementing 
Basel II contemplates allowing capital levels to fall to an 85 
percent ``floor.'' How can the agencies know, even before the 
``parallel run'' contemplated for 2008, that a drop of 15 
percent in the capital of banks would be consistent with safety 
and soundness considerations?

A.16. Experience has taught us that existing Basel I risk-based 
capital rules do not always afford a capital requirement 
commensurate with the risk of the asset. In addition, by virtue 
of the 100 percent risk-weight ceiling, Basel I-assigned risk 
weights are not 
always sufficient to address the credit risk of higher risk 
assets. Under the current draft of the Basel II NPR, each core 
or opt-in banking organization would have to adequately measure 
and model risk. An institution that has a low risk portfolio, 
for example a portfolio of traditional, amortizing home 
mortgage loans, would appropriately be able to reduce its risk-
weighted assets, in some cases down to the floors. Another with 
a higher risk profile would, in theory, see its risk-weighted 
assets increase. As part of the implementation process, each 
core or opt-in institution would have to receive the approval 
of its regulator before moving forward from the parallel run, 
and into each of the next three periods of potentially 
reduced capital requirements. The floors would be assessed on 
an institution-by-institution basis. The floors are intended to 
ensure that any reduction in capital (if at all, and then, only 
as approved by the primary regulator) can be no more than an 
incremental percentage reduction. The agencies will seek public 
comment on the proposed floor and floor amounts. All of these 
provisions would be subject to change based on the analysis of 
the comments. Moreover, if the regulators do not believe that a 
banking organization's indicated reduction in capital is 
warranted, they would not approve the move from one level to 
the next. Within each level of these steps, the OTS's foremost 
concern is safety and soundness.

Q.17. Basel II's capital formulas are based on highly complex 
models that are to be implemented on a bank specific basis. 
While Basel I has been criticized for its over-simplification, 
the sheer complexity of Basel II has raised some very serious 
concerns. In his written testimony, Mr. Isaac states, ``Basel 
II is so complex it cannot be adequately understood by senior 
bank managements, boards of directors, regulators, or the 
public.'' Professor Kaufman states, ``Increased complexity is 
likely, however, to both increase compliance costs and reduce 
understanding, particularly by the bank CEO, board of 
directors, and possibly even the CFO and by bank supervisors.'' 
Do you share Mr. Isaac and Professor Kaufman's concerns? If you 
share their concerns, what recommendations do you have for the 
regulators as to how to fix this problem?

A.17. While the new framework is complex, so is modern 
enterprise-level risk management at the largest U.S. banking 
organizations. The current draft of the Basel II NPR is based 
on a value-at-risk approach to capital. The value-at-risk 
model, and similar approaches, is already widely used at the 
more sophisticated institutions. In fact, one of the most 
important components of the proposal would be the ``use'' test 
that requires institutions to build on their own internal risk 
management models in meeting the proposed requirements.
    The current draft of the Basel II NPR reflects the 
complexity of many large institutions. Thus, it would supply 
the agencies with a sufficient and sophisticated tool to 
measure these complex businesses. Under Basel I-based rules, 
the agencies had concern we were missing an accurate assessment 
of complex activities. However, the new proposal is not 
suitable for all institutions. The appropriate question then is 
whether the senior management at the largest institutions would 
be able to understand proposed requirements. Although there is 
a danger that Basel II could reduce understanding if not 
properly implemented, in general, we do not share Mr. Isaac's 
and Dr. Kaufman's concern that the proposal is beyond the 
comprehension of senior management at such institutions. In 
addition to supporting guidance that would be issued 
following the publication of the Basel II NPR, and which should 
mitigate some of the complexities, OTS will ensure that 
management and boards are properly addressing these 
complexities. As regulators, we will enhance our own expertise 
so we can provide the required oversight.

Q.18. According to FDIC data, the equity to capital ratio of 
insured U.S. financial institutions reached a low of slightly 
above 5 percent in the late 1980's, during the S&L crisis, and 
then rose steadily through the 1990's reaching the level of 
over 10 percent, at which it stands today. Profits--as measured 
by return on assets--which had fallen dramatically during the 
period of low capital, also began a steady rise in the 1990's, 
rising together, it becomes clear that large profits and strong 
levels of capital can coexist. Do you agree that strong levels 
of bank capital can and do coexist with strong bank 
profitability?

A.18. Strong levels of capital and profits can coexist. The 
goal of the current draft of the Basel II NPR is not to reduce 
capital, but to make it more risk-sensitive, so that we do not 
inadvertently advantage or disadvantage any type of lending by 
requiring too little or too much capital for the risks 
involved.

Q.19. Under the Administrative Procedure Act, agencies are 
required to consider public comment prior to issuing new final 
regulations. How can the agencies fully comply with this 
requirement? Doesn't the fact that the agencies reached an 
international agreement on the new capital framework 
effectively limit their ability to fully consider public 
comment and modify proposed regulations in light of that 
comment?

A.19. OTS will fully comply with the requirements of the 
Administrative Procedure Act. The timelines for the Basel II 
NPR and the Basel I-A NPR are being coordinated to permit 
industry consideration of, and public comment on, the two 
rulemakings along overlapping timeframes. OTS will consider all 
comments, and take 
action to address those comments as appropriate. The 
international accord does not limit the agencies' ability to 
make appropriate revisions in response to public comment. The 
agencies would not be bound to adopt all aspects of the Basel 
II Accord. Rather, the Basel II Accord provides a range of 
options for determining the capital requirements for credit and 
operational risk, allows national supervisors to select 
approaches that are most appropriate for their 
financial markets, and specifically recognizes the need for 
national discretion in the implementation of various matters.

Q.20. The Basel II framework ignores a significant risk: 
Interest rate risk. Many banking assets, such as mortgage 
servicing rights, are extremely sensitive to changes in 
interests rates, and the value of assets such as these may 
fluctuate dramatically when interest rates change. How do you 
propose to take interest rate risk into account under the Basel 
II framework?

A.20. OTS agrees that an interest rate component is critical. 
In fact, OTS has employed an interest rate risk model since 
1992, and has comprehensive policies regarding appropriate 
interest rate risk management. Interest-rate risk is addressed 
under Pillar 2 of the Basel II Accord, and the agencies plan to 
specifically invite comment on interest rate risk in the Basel 
II NPR. Moreover, OTS is committed to developing interagency 
guidance to ensure that interest rate risk is measured and 
capitalized adequately, and that it is benchmarked for 
consistent treatment by the supervisors for all banking 
organizations, especially mortgage lenders. Interest rate risk 
in the trading book would also be captured as part of the 
market risk capital requirements of Pillar 1. While OTS does 
not currently have a market risk rule, OTS intends to propose a 
market risk rule in 2006.

Q.21. Due to the tremendous devastation caused by Hurricanes 
Katrina and Wilma this fall, it is estimated that over 100,000 
homes have been lost. Would the Basel II framework have 
provided institutions with enough capital buffer to handle a 
calamity of this magnitude?

A.21. The well-capitalized position of thrifts was a source of 
strength for local community thrifts impacted by Katrina or 
Wilma. Capital, however, cannot protect an institution against 
every kind of conceivable catastrophic event, and it is not the 
only tool to ensure an institution can endure such events. 
Other tools include the ability to mitigate and manage risk by 
ensuring strong underwriting, and by requiring flood, property, 
and casualty insurance, as appropriate.

Q.22. Last week, on November 18, 2005, the Financial Times 
published an editorial by Harold Benink and Jon Danielsson 
titled, ``There is a chance to correct the defects of Basel 
II.'' Harold Benink is Professor of Finance at RSM Erasmus 
University in the Netherlands. Jon Danielsson is a Reader in 
Finance at the London School of Economics. They concluded: 
``Instead of requiring bank capital to be risk sensitive, 
banking regulation should simply require the use of high 
quality risk models in banks without using their output to 
determine capital. Minimum capital is better calculated as a 
simple fraction of bank activity in broad categories.'' What is 
your response to this suggestion?

A.22. This suggestion ignores a financial institution's ability 
to manage risks, and places a minimum capital standard on all 
institutions regardless of their sophistication. It is this 
type of conservatism in capital standards that could price 
larger institutions out of global markets and severely limit 
their ability to compete. The United States has a somewhat 
unique regulatory environment in that it requires a simple 
leverage ratio as a backstop. The leverage ratio requirement 
provides for a simple fraction of financial activity as 
Messer's Benink and Danielsson advocate.
    The simplicity of broad categories, while attractive, can 
mask significant differences in actual risk. For example, all 
qualified residential mortgages receive a 50 percent risk 
weight under the Basel I-based rules. However, actual risk can 
vary among mortgages in that category. Because of this 
structure, banking organizations face misaligned incentives.

Q.23. In his testimony, Mr. Isaac states, ``I have not found a 
single professional bank supervisor who is enthusiastic about 
Basel II.'' We have also heard of a similar lack of enthusiasm 
on the part of the supervisors who will actually be responsible 
for supervising Basel II. What is your response? Separately, 
what gives you confidence that regulators will be up to the 
task of understanding and policing Basel II?

A.23. OTS supports moving forward cautiously with the Basel II 
NPR. We also recognize that anything new and complicated often 
receives a mixed response from those familiar with systems that 
are more routine and simple. However, as supervisors we must 
adapt to change to keep our supervision relevant, 
sophisticated, and effective. In order to succeed in an 
increasingly complex financial world, banking organizations are 
developing sophisticated 
internal models and financial risk management approaches to 
manage their businesses. They participate as intermediaries in 
transactions that would not have been contemplated a decade 
ago. As supervisors of those organizations, we must also remain 
dynamic and enhance our knowledge of capital measurement and 
management in a faster, more complex, financial world. If we 
fail to do so and remain in a 1980's risk-based capital system, 
we will miss those risks, and safety and soundness will suffer.
    The current draft of the Basel II NPR promises complex and 
new approaches to capital measurement and management at our 
thrifts. As stated in response to earlier questions, we are 
hiring and training staff in order to ``retrofit'' capital 
supervision, risk analysis, and risk assessment to the 
challenges posed to our institutions, and hence to us. In 
conjunction with the careful and deliberative implementation 
plan outlined by the agencies, OTS is confident it can meet 
these challenges.
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