[Senate Hearing 109-1084]
[From the U.S. Government Publishing Office]
S. Hrg. 109-1084
AN UPDATE ON THE NEW BASEL CAPITAL ACCORD
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
ON
THE RECENT DEVELOPMENTS REGARDING THE IMPLEMENTATION OF BASEL II AND
BASEL IA AND THE CONCERNS RAISED ABOUT THE BASEL II REGULATIONS
PROPOSED BY FEDERAL BANKING REGULATORS
__________
TUESDAY, SEPTEMBER 26, 2006
__________
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
William D. Duhnke, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Andrew Olmem, Counsel
Lee Price, Democratic Chief Economist
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
C O N T E N T S
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TUESDAY, SEPTEMBER 26, 2006
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 2
Senator Johnson.............................................. 4
Senator Schumer.............................................. 5
Senator Carper............................................... 24
WITNESSES
John C. Dugan, Comptroller of the Currency....................... 8
Prepared statement........................................... 51
Response to written questions of:
Senator Shelby........................................... 175
Senator Sarbanes......................................... 179
Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation.. 9
Prepared statement........................................... 64
Response to written questions of:
Senator Shelby........................................... 183
Senator Sarbanes......................................... 187
Susan S. Bies, Governor, Federal Reserve Board of Governors,
Federal Reserve System......................................... 11
Prepared statement........................................... 78
Response to written questions of:
Senator Shelby........................................... 191
Senator Sarbanes......................................... 196
John M. Reich, Director, Office of Thrift Supervision............ 13
Prepared statement........................................... 91
Diana L. Taylor, Superintendent of Banks, New York State Banking
Department..................................................... 14
Prepared statement........................................... 102
Response to written questions of:
Senator Sarbanes......................................... 224
James Garnett, Head of Risk Architecture, Citigroup.............. 35
Prepared statement........................................... 118
Kathleen E. Marinangel, Chairman, President, and CEO, McHenry
Savings Bank................................................... 36
Prepared statement........................................... 127
William M. Isaac, Chairman, Secura Group, LLC.................... 37
Prepared statement........................................... 152
Daniel Tarullo, Professor of Law, Georgetown University Law
Center......................................................... 39
Prepared statement........................................... 160
Additional Material Supplied for the Record
Prepared statement of the Independent Community Bankers of
America........................................................ 230
AN UPDATE ON THE NEW BASEL CAPITAL ACCORD
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TUESDAY, SEPTEMBER 26, 2006
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:06 a.m., in room SD-538, Dirksen
Senate Office Building, Senator Richard Shelby (Chairman of the
Committee) presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The Committee will come to order.
Today we will continue our oversight of the new Basel II
Capital Accord and the proposed revisions to existing capital
requirements, known as Basel IA. After years of development and
consideration, we are now entering into a critical phase for
the implementation of Basel II and Basel IA. Federal banking
regulators recently approved the Notice of Proposed Rulemaking
for Basel II and are expected to issue shortly the Notice of
Proposed Rulemaking for Basel IA.
During the public comment period for these regulations,
Federal banking regulators will consider whether any
modifications are necessary before the regulations become
final. The decisions Federal banking regulators make over the
next few months will have profound consequences for the long-
term stability of the U.S. economy.
Capital requirements play a key role in ensuring the safety
and soundness of our banking system and protecting U.S.
taxpayers from the cost of bank failures. We only need to look
at U.S. economic history to see how thinly capitalized banks
have in the past made our financial system vulnerable to
unanticipated economic shocks and how a crisis in the banking
system quickly infects the rest of our economy. And due to the
existence of Federal deposit insurance, in the end, taxpayers
pay the cost of bank failures attributable to a lack of
capital.
The risks posed by undercapitalized banks are heightened by
the rapidly increasing sophistication of our financial system.
In the world of derivatives and off-balance-sheet transactions,
it is vital that banks utilize advanced risk management
practices to effectively monitor and control their financial
exposures. Accordingly, Basel II and Basel IA must be
implemented within the utmost care and diligence. There is
little margin for error when it comes to capital requirements.
Yet concerns have been raised about the Basel II NPR.
At the Committee's last hearing on Basel II, we heard
testimony that questioned whether Basel II would leave banks
sufficiently capitalized and whether regulators possess the
expertise necessary to implement Basel II. Furthermore, several
banks have requested that they be allowed to choose the
Standardized Approach for setting their capital requirements.
Currently, banks adopting Basel II in the U.S. will be
permitted to use only the Advanced Approach. Before Basel II
and Basel IA go forward, I believe we must have a clear picture
of how they will change our financial system. We must also know
that our banks will hold the appropriate amount of capital,
that our regulators will be able to implement a regime as
complex as Basel II, and that our small banks will not be
placed at a competitive disadvantage.
I look forward to hearing the witnesses' testimony on these
important questions today. At today's hearing we will have two
panels.
The first panel will consist of the Honorable John Dugan,
Comptroller of the Currency; the Honorable Susan Schmidt Bies,
Governor of the Federal Reserve Board of Governors, a member of
the Federal Reserve; the Honorable Sheila Bair, Chairman of the
Federal Deposit Insurance Corporation; the Honorable John
Reich, Director of the Office of Thrift Supervision; and the
Honorable Diana Taylor, Superintendent of the New York State
Banking Department, on behalf of State Banking Supervisors. We
will just go to the first panel first.
Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Well, thank you very much, Chairman
Shelby. I want to commend you for holding not just this hearing
but a series of hearings on the status of Basel II. There have
been very important developments since our last hearing. I am
sure this hearing today will help us to understand those.
As people know, and let me just say at the outset, I am
very skeptical of proposals that would reduce bank capital
requirements or threaten to do so in the future.
Like others on this Committee, I have been around long
enough to remember the difficult years of the late 1980s and
early 1990s when our banking system became undercapitalized.
Some banks and thrifts had negative capital and were closed.
Most others were forced to increase their capital, and in that
period, the American taxpayer paid an enormous cost to make
good on the promises of deposit insurance. We were here
together, I think, in those days, Mr. Chairman.
Chairman Shelby. Dark days.
Senator Sarbanes. I do not think anyone on this Committee
would want to go through an experience like that again.
When banks are forced to rebuild their capital, they make
fewer loans to the riskier startup businesses that are
important to job creation. But we managed through legislation
and regulation to get our banking system back on a firmer
footing. Many experts believe that the U.S. economic
performance was much better than the Japanese performance in
the late 1990s because our banking system had successfully
recapitalized and the Japanese banking system had not. Strong
bank capital protects taxpayers and promotes healthy and stable
economic growth. And, furthermore, it does not appear to have
hurt the profitability of our Nation's banks. They are earning
record profits and are doing much better than their competitors
abroad, even though, it is constantly pointed out, the foreign
banks have lower capital requirements.
Many experts welcomed the original Basel I in the 1980's as
an unprecedented accord among bank regulators in the U.S.,
Europe, Japan, and Canada to raise bank capital requirements.
Over the years, it has been updated many times, but in the late
1990's it was decided to develop a new agreement, Basel II.
Basel II was finalized in 2004. It provides for three different
approaches for capital regulations: standardized, foundational,
and advanced internal ratings-based.
The Federal Reserve has taken the lead in long maintaining
that the Advanced Approach should be mandatory for our largest
banks. My concern with this is that the Advanced Approach under
Basel II may indeed end up threatening the safety and soundness
of our banking system.
Last year, a year after the terms of Basel II were settled,
we learned the likely effect of the Advanced Approach on bank
capital requirements. The so-called QIS-4 study of 26 of our
largest banks found that the capital requirements in one
instance for one of those banks would plunge nearly 50 percent
and the capital requirements for half of the banks would fall
at least 26 percent.
Seeing these results--in fact, we had been constantly
assured in testimony before this Committee that there was not
going to be a substantial reduction in bank capital. Seeing
these results, the four bank regulators wisely agreed--I gather
with some internal dissension--that they should maintain the
leverage ratio, slow the decline in any one bank's capital, and
limit the decline in overall capital in the banking system.
I have yet to hear a single outside expert on our banking
system argue that our banks today are overcapitalized. In fact,
Bill Isaac, who will be testifying on the second panel, says in
his statement, and I quote him, talking about the original
premise behind Basel II about developing these mathematical
capital models while broadly maintaining the overall level of
capital: ``The models--incomprehensible to mere mortals, such
as boards of directors and senior management of the banks''--
and Members of Congress. That is my addition, not his. He is
very polite to the Members of the Congress. He left us out of
this problem.
Chairman Shelby. At least here.
Senator Sarbanes [continuing]. ``Would measure the risks in
these institutions' assigned capital to cover those risks.''
``This original premise was somehow transferred into an
expectation that large banks would be offered the carrot of
reduced capital in exchange for developing the models. Let us
pause right here''--this is Isaac--``and think about the
proposition that the largest banks have excess capital and
should be allowed to reduce their capital materially.''
``Does anyone really believe in that notion--particularly
anyone who lived through the two decades in banking from 1973
to 1993? Thousands of banks and thrifts failed during that
period--many more, including most of the largest banks, would
have failed but for very strong and costly actions taken by the
FDIC and the Federal Reserve to maintain order. It was a very
scary period that nearly careened out of control.''
``For any regulator to accept the premise that the world's
largest banks as a group have significant excess capital is
unfathomable to me, yet that is the glue holding Basel II
together.''
Now, I also worry about the complexity and potential
conflict of interest in the structure of the Advanced Approach.
For many of these reasons, the limits on capital reduction
allowed under the Advanced Approach makes a lot of sense.
Now, over the summer, a new proposal emerged that would
allow all banks to use the Standardized Approach. This proposal
has won the endorsement of large and small banks, bank
associations, and State bank regulators. The four bank
regulators recently decided to seek public comment on this
proposal in their Notice of Proposed Rulemaking.
The Standardized Approach appears to have the merit that it
would apparently not lead to large reductions in required bank
capital. I have been concerned about this effort to achieve
large reductions in capital requirements, and I know that some
in the banking industry pushed for this Advanced Approach, but
without the restrictions on how low their capital could go.
The Standardized Approach also addresses the concerns that
the Advanced Approach would favor the largest banks at the
expense of smaller banks.
So, Mr. Chairman, this is a very important hearing, and
again, I commend you for scheduling it. I want to just close by
again quoting Bill Isaac, who, of course, had the distinguished
service as a former Chairman of the Federal Deposit Insurance
Corporation. At the close of this statement he says, and I
quote him, ``This is by far the most important bank regulatory
issue in front of us today. If we get this one wrong, our
Nation and taxpayers will almost certainly pay a very big price
down the line--a price that will make the S&L debacle seem like
child's play.''
Thank you very much.
Chairman Shelby. Senator Johnson.
STATEMENT OF SENATOR TIM JOHNSON
Senator Johnson. Chairman Shelby and Ranking Member
Sarbanes, thank you for holding today's hearing on Basel II
Capital Accord. One of the most important duties of this
Committee is to ensure the safety and soundness of our
financial system, and oversight of Basel II is a critical
element of that responsibility.
As we consider the state of Basel II, I would urge the
regulators not to lose sight of three main goals.
First, all banks deserve a level playing field. I am
pleased that we seem well on our way to solving the domestic
competitiveness concerns that confronted us last year, and I
would like to thank the regulators for taking those concerns
seriously. I look forward to reviewing the forthcoming Basel IA
proposal, and I also support offering all banks of whatever
size the internationally negotiated Standardized Approach.
Small community banks remain the lifeblood of many of our
communities, and Basel II must not impair their ability to
compete.
Ironically, though, we appear now to be on the verge of
placing large internationally active U.S. banks at a serious
disadvantage against foreign competitors, and even against U.S.
consolidated supervised entities. I would urge the regulators
to review the U.S. banking Notice of Proposed Rulemaking to
avoid duplicative requirements and to take great care before
piling on a host of new requirements that diverge from the
international version of Basel II.
Second, risk-based capital should remain a priority.
Clearly, our main concern must be the safety and soundness of
U.S. financial institutions. However, it has been well
established that more capital is not always better. In fact,
the recognition that more is not always better is largely why
we embraced the Basel negotiations in the first place. The
current system, which fails to peg capital to risk, perversely
encourages risk-taking. Basel II recognizes that when risk and
regulatory capital are aligned, capital is adequate but not
excessive, and banks are forced to internalize their risks. We
all benefit from the right balance.
The challenge, of course, is identifying the optimal
balance. Under our risk-based system capital is meant to change
depending on the risk of the underlying asset or activity, as
well as underlying economic conditions. In reviewing the impact
of any proposed rule, it is important to keep in mind that not
all capital drops are bad. Of course, some may well be bad, and
that is the point of Pillars 2 and 3.
Third, international harmonization should be a goal. In
reviewing the newly published NPR, I am very concerned that we
are undervaluing the creation of uniform international capital
standards. The marketplace for products and services is
increasingly global; therefore, it is critical that everyone
plays by the same rules and U.S. banks are not disadvantaged.
Of course, we need to make sure that the system works and banks
are closely monitored. But the number of significant changes to
the international text, which would apply only to U.S. banks,
strikes me as a strange and unwanted result given our original
goal of international harmonization.
Mr. Chairman, I think we would all agree that we have some
way to go on Basel II to get it right. Clearly, all of the
regulators have devoted considerable time, energy, and
resources to ensuring the safety of our institutions and the
vitality of our economy, and I value that dedication. I urge
you in the coming months to continue working together to
achieve the necessary balance in Basel II. I also urge the
regulators to keep an open mind to giving all banks of whatever
size the option of implementing the international version of
the Standardized Approach.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Schumer.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Well, thank you, Mr. Chairman. I really
want to thank you for holding this timely hearing. We are
fighting to remain competitive in the financial markets. I
think every American wants us to stay No. 1, but no one more
than those of us who represent New York City, which is our
financial capital. And we have a tremendous dilemma here and
not just in this area.
As the world economy becomes internationalized and
financial markets become one, you run the tension between
having a system of regulation--which with this country has
worked extremely well. I think in the last quarter of the 20th
century, we achieved quite an exquisite balance. I have always
said I like people who are both pro-business and pro-
regulation, and I think there is no contradiction between the
two. Those on the left wing who just want to regulate,
regulate, regulate, and tie the hands of an entrepreneurial
system, that makes no sense. And those on the right wing who
just say do whatever business wants have not learned the
lessons of history, plain and simple.
So there is a balance and we achieved it, but now it has
sort of been thrown up in the air because of
internationalization. And you can run into the problem of
lowest common denominator. In other words, the place with the
least regulation, that is where people will go, because
regulation is a public good and it does not affect the
individual making the deal unless the whole system collapses.
You know, there is a book by Mancur Olson, ``The Logic of
Collective Action,'' which is very relevant here, which talks
about that.
Well, I have to disagree with some of my Democratic
colleagues who say we must keep every regulation in place
because they have worked in light of the international
challenge. But I disagree with saying let's get rid of them all
as well. We have to find that balance, and this hearing is an
attempt to do it.
Now, let me make some comments here. We have all heard
about IPOs, only one of the top 24 being registered in the
U.S., four in London. But listen to this: London already
accounts for 70 percent of global bond trading, 40 percent of
derivatives, 30 percent of foreign exchange activity, and 30
percent of cross-border equities.
As Senator from New York, these are the kinds of things
that keep me awake at night, and I know they keep our great
banking superintendent, Diana Taylor, who is here, awake as
well. Hi, Diana. Nice to see you.
Ms. Taylor. Hello. Thank you.
Senator Schumer. Now, with respect to Basel II, I was there
when Basel was--you know, I was involved as a Congressman on
the Banking Committee when Basel started up. We all thought it
was a great thing. We had seen the banking crisis, the S&L
crisis, and we knew that capital standards, rather than strict
regulation, were the way to go. Plain and simple.
Now we have not had a banking crisis for 15 years, so the
need to have capital standards sort of declined a little bit.
But we need them.
The problem is, again, when other countries say we are
going to do much less, the imperative of New York companies,
American companies to their stockholder says, well, if we can
be more profitable doing it over there, we should. That is the
dilemma we face, and if we are too rigid, we will lose all the
business, and we will have no regulation and no business. If we
are not rigid enough--I mean, if we are too flexible, we will
have the kinds of crises we saw before.
So, as I said, we need to look at this carefully.
Everything is interconnected. One failure is going to lead to
the failure of many, and it is going to hurt taxpayers. So we
have to be careful. We have to be careful.
But we should not fool ourselves into thinking a bigger
capital cushion always means a safer system. Advances have
occurred in risk management. Management makes it possible to
use capital requirements to make banks internalize their risk,
and if a bank takes a calculated risk, obviously it should have
more capital in those investments than the ones that do not.
But if they have to hold onto too much capital against safe
activities, that is where we are losing out, and I think that
is the nub of this problem that we have to look at.
So a number of Members have discussed these issues, but I
have to say candidly I am concerned that at a time when we are
struggling to maintain our stature as the world's economic
center, this Notice of Proposed Rulemaking can hurt our ability
to compete with France, Germany, and Japan, and particularly
London. And make no mistake about it, London is making a strong
effort to replace New York as the financial capital. Their
regulators are here. They actually go solicit companies, which
we are not doing. And, in fact, I formed a little group along
with Mayor Bloomberg to discuss what we should do, and we are
going to be examining that very seriously in the next few
months.
So let me say here I believe in giving all banks access to
the international Standardized Approach, and that is an
important step and I support it. At least banks will have one
option that allows them to follow the same rules as the rest of
the world. And with respect to the Advanced Approach, I am a
little less optimistic. I take pride in representing the
world's financial capital. I want to make sure that our noble
intentions do not backfire, and we need to keep the system safe
and strong. We need to give New York banks a fair shot.
By the way, they are not New York banks anymore. They are
in New York, but they are international banks, and they could
locate somewhere else very quickly. And that is their job. I
would get mad at them if they do it. I would fight less hard
for them if they did it. But their first obligation is to their
stockholders. And so this is a real dilemma.
Senator Schumer. And one other point, Mr. Chairman. There
would be value if the GAO were to look at how any differences
in the bank proposal could affect U.S. banks. So I am going to
ask the GAO to conduct an expedited impartial analysis to
report on the differences between the U.S. and foreign
implementation of Basel II to determine which differences could
have an adverse competitive consequence on U.S. banks and an
adverse consequence on safety and soundness.
And with that, Mr. Chairman, I really thank you for holding
this timely and important hearing.
Chairman Shelby. Thank you, Senator Schumer. Comptroller
Dugan, we will start with you. All of the written testimony
will be made part of the hearing record in its entirety. A lot
of you are not strangers here, so you proceed.
STATEMENT OF JOHN C. DUGAN,
COMPTROLLER OF THE CURRENCY
Mr. Dugan. Chairman Shelby, Senator Johnson, and Senator
Schumer, I appreciate this opportunity to discuss the U.S.
banking agencies' proposals to enhance our regulatory capital
program under Basel II.
The U.S. implementation of Basel II is, at its core, the
effort to move away from the simplistic Basel I capital regime
for our largest internationally active banks. The inadequacies
of the current framework are pronounced with respect to these
banks, which is a matter of great concern to the OCC because we
are the primary Federal supervisor for the five largest. These
institutions, some of which hold more than $1 trillion in
assets, have complex balance sheets, take complex risks, and
have complex risk management needs that are fundamentally
different from those faced by community and mid-sized banks.
Because of these attributes, Basel II is necessarily
complex, but it would be mandatory for only a dozen large U.S.
institutions. The new regime is intended not only to align
capital requirements more closely to the complex risks inherent
in these largest institutions, but, just as important--and this
is a total departure from the existing capital framework--it
would also require them to substantially improve their risk
management systems and controls. This would be accomplished
using a common framework and a common language across banks
that would allow regulators to better quantify aggregate risk
exposures, make more informed supervisory decisions, disclose
more meaningful risk information to markets, and make peer
comparisons in ways that we simply cannot do today.
Earlier this month, the agencies took a critical step
forward in this process by approving a notice of proposed
rulemaking. In addition to establishing the basic Basel II
framework in the United States, the NPR addresses two key
issues about implementation.
The first concerns the reliability of the framework itself.
As you know, last year's quantitative impact study of the
potential impact of an earlier version of Basel II predicted
substantial drops and dispersions in minimum required capital.
These QIS-4 results would be unacceptable to all the agencies
if they were the actual results produced by a final, fully
supervised and implemented Basel II rule. But they were not.
Some changes already made in the proposed rule--and others that
will be considered during the comment period--should mitigate
the QIS-4 results. More important, we believe that a fully
supervised implementation of a final Basel II rule, with
examiners rigorously scrutinizing the inputs provided by banks,
is likely to prevent unacceptable capital reductions and
dispersions.
We cannot be sure, however, and that is why the proposed
rule will have strict capital floors in place to prevent such
unacceptable results during a 3-year transition period. This
will give us time to finalize, implement, supervise, and
observe ``live'' Basel II systems. If during this period we
find that the final rule would produce unacceptable declines in
the absence of these floors, then we will have to fix the rule
before going forward, and all the agencies have committed to do
just that.
The second issue concerns optionality. The NPR asks whether
Basel II banks should have the option of using a simpler
approach. This is a legitimate competitive question, given that
the largest banks in other Basel II countries have such an
option, although, as a practical matter, all such foreign
competitors appear to be adopting the Advanced Approaches. We
are very interested in comments about the potential competitive
effects of providing such an option to U.S. banks.
The OCC has been a frequent critic of many elements of the
Basel II framework, and we have worked hard to make important
changes to the proposal that we thought made sense. But at
critical points in the process, the OCC has supported moving
forward toward implementation, and our reason for doing so is
simple. An appropriate Basel II regime will help both banks and
supervisors address the increasingly complex risks faced by our
very largest institutions. While we may not yet have all the
details right, and we will surely make changes as a result of
the public comment process, I fully support the objectives of
the Basel II NPR for the supervision of our largest banks.
Likewise, for non-Basel II banks, I fully support our
interagency effort to issue the so-called ``Basel IA'' proposal
in the near future as a way to more closely align capital with
risk without unduly increasing regulatory burden.
In closing, let me emphasize that, as we move forward with
these proposals, the agencies will continue to foster an open
process, consider all comments, heed good suggestions, and
address legitimate concerns.
Thank you very much.
Chairman Shelby. Chairman Bair.
STATEMENT OF SHEILA C. BAIR, CHAIRMAN,
FEDERAL DEPOSIT INSURANCE CORPORATION
Ms. Bair. Thank you, Chairman Shelby, Senator Sarbanes,
Members of the Committee. I appreciate the opportunity to
testify on behalf of the Federal Deposit Insurance Corporation
concerning the Basel II International Capital Accord.
At the outset, I would like to emphasize that we all
support moving ahead to the next step in the Basel II
deliberative process. The FDIC Board of Directors recently
voted to publish the Basel II Notice of Proposed Rulemaking for
public comment. U.S. bank and thrift regulators also are
developing a more risk-sensitive capital framework for non-
Basel II banks, known as Basel IA, which we hope to publish for
comment in the near future.
While it is important to move ahead with the process, there
is also agreement that we must not do so in a way that will
result in significant reductions in capital or in the creation
of wide disparities in capital among different types of insured
depository institutions.
The agencies' most recent QIS study suggested that the
Basel II Advanced Approaches would result in a substantial
reduction in risk-based capital requirements. The results also
showed wide variations in capital requirements for similar
risks. The agencies found these results unacceptable, and as a
result, included a number of important and essential safeguards
in the NPR to address them.
I look forward to the comments on the NPR, and I will
approach those comments with an open mind. I particularly look
forward to comments on the question of whether the regulators
should allow alternatives to the Advanced Approaches. We have
had a number of requests to allow any U.S. banks to use the
Standardized Approach to capital regulation that is a part of
the Basel II Accord. The U.S. is the only country proposing to
make the Advanced Approaches mandatory for any group of banks.
The Standardized Approach includes a greater array of risk
rates than the current rules. It is simpler and less costly to
implement than the Advanced Approaches. In addition, because
there is a floor for each risk exposure, it does not provide
the same potential for dramatic reductions in capital
requirements.
On the other hand, there is the argument that only the
Advanced Approaches would provide an adequate incentive for the
strengthening of risk measurement systems at our largest banks.
Whether our largest banks should be required to use the
Advanced Approaches is a fundamental issue, and as I just
mentioned, I look forward to public input on this question.
Before concluding my remarks on Basel II, I would like to
say a few words about the leverage ratio. The FDIC has
consistently supported the idea that the leverage ratio, a
simple capital-to-assets measure, is a critically important
component of our dual capital regime. I am pleased that all the
bank regulators have expressed their support for preserving the
leverage ratio. I appreciate that banks in most other Basel
Committee countries are not constrained by a leverage ratio and
that effective capital standards around the world vary widely
as a result. Indeed, if large European banks were subject to
the U.S. Prompt Corrective Action standards, several would be
considered as undercapitalized.
For this reason, I believe that the United States should
ask the Basel Committee to initiate consideration of an
international leverage ratio. The leverage ratio has provided
U.S. supervisors with comfort that banks will maintain a stable
case of capital in good times and bad. Similarly, the
establishment of an international leverage ratio would go far
in strengthening the liquidity and stability of the
international banking system and help limit the consequences of
reduced risk-based capital levels with Basel II implementation.
In conclusion, it is important that we improve the current
risk-based capital rules without significantly reducing capital
requirements. In addition, we should not allow ourselves to be
drawn into a debate about lowering capital ostensibly as a
means of promoting international competitive advantage. The
U.S. has always had high capital standards, and this has been a
source of strength, not weakness, for our banking system.
I will support implementing the Advanced Approaches only if
I can develop a comfort level that strong capital levels will
be preserved. To this end, I will review with an open mind the
possibility of allowing the U.S. version of the Standardized
Approach as an alternative option for implementation of Basel
II.
In addition, as I indicated, the Basel Committee should
consider an international leverage ratio as a way to promote
liquidity and ensure a baseline of capital for safety and
soundness throughout the global banking system.
I look forward to working with my fellow regulators to
achieve a consensus on an outcome that is in the public
interest. I appreciate the opportunity to testify regarding
Basel II and look forward to answering any questions the
Committee may have.
Thank you.
Chairman Shelby. Thank you.
Governor Bies.
STATEMENT OF SUSAN S. BIES, GOVERNOR, FEDERAL RESERVE BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM
Ms. Bies. Thank you, Mr. Chairman, and I appreciate the
attention of the Members of the Committee.
First of all, I think holding this hearing at this time
recognizes the major events that have occurred in the last
month, where we have issued the Basel II NPR and also the
market risk NPR which will, for the first time, provide similar
capital treatment for securities and banking firms in the
United States. It implements a global accord between the Basel
Committee on Banking Supervision and IOSCO, and I think that
also is a major step forward in getting a more level playing
field.
Let me focus today in my remarks on Basel II and where we
are. As has already been mentioned, Basel II and our NPR are
proposing that the core banks, who we define as the very
largest and internationally active banks--it would be about a
dozen--would have to adopt the most Advanced Approaches, the A-
IRB for credit risk, and the Advanced Measurement Approach, the
AMA for operational risk.
The U.S. proposed framework has been compared with the
Basel framework other countries will implement where there are
a variety of options in the Basel II framework. One point I
would like to make, though, is in many countries Basel I goes
away when that country adopts Basel II. We have made the choice
in the United States to maintain Basel I for the vast majority
of our banking institutions. For those countries where Basel I
goes away, banks in those countries who are both small and
large, therefore, need a variety of approaches. And so some of
the Standardized Approaches were designed by the Basil
Committee with the smaller, simpler organizations in mind when
Basel II was drafted. And I think that is one of the questions
we will want to get comments on in the NPR, of how that would
apply in the United States.
The other point I would like to make is that we do know
that while there is large variety, the largest globally active
banks at this time are indicating that all of them are going to
adopt the Advanced Approaches, and that has been stated most
recently in a public format in the Basel Committee's report on
QIS-5. The United States did not participate, but the other
major countries did, and that is what the large international
banks indicated at that time.
Chairman Shelby. Does that include the Japanese banks?
Ms. Bies. Yes.
We also have focused so much attention on Pillar 1, I hope
people also recognize that Pillar 2 is there. Pillar 2 involves
processes to address the kinds of risks that aren't captured in
credit or operational risks in Pillar 1. It can require
additional capital if there are those other risks, and it is
part of the supervisory process that makes the Basel II
Framework so effective.
Finally, in looking at alternative approaches under Basel
II, we also hope we get comment on what the implications are
for Pillar 3. Pillar 3 is the public disclosure standard of the
Basel II Capital Accord. One of the challenges here is that we
had envisioned in the U.S. NPR to have the very complete
disclosure of risk that the more sophisticated models would
entail. The question then is: will the disclosures under a
Standardized Approach to Pillar 1 be sufficient to give good
disclosure of how risks are managed so we have market
discipline about risk-taking of the largest organizations.
We continue to believe at the Fed that Basel I is
inadequate for the largest, most complex U.S. banking
organizations because they cannot fully capture the array of
risks that these institutions face. Basel I does not recognize
operational risk embedded in many services, and in our Basel I
NPR that we are working on, as we did in the A-NPR, we do not
anticipate an operational risk. Now there is a question that
has been added about how to deal with operational risk if we
provide a standardized credit risk approach.
Basel I also does not differentiate the riskiness of assets
within asset types, and we have learned that the large
organizations have quite a variety of the kind of risk exposure
even though they have similar asset types.
Basel II draws upon many of the economic capital models
that the banks use for their own risk management. But one of
the challenges that we have seen is understanding the validity
that these models have because they have different approaches.
Already through the working in QIS-4 and -5, regulators are
understanding that by requiring a more standardized framework,
it allows us more effectively to have transparency into how
those models work and gives us an ability to assess and
identify weaknesses in risk management models. And for that
reason, we also think that it is an important goal to support
Basel II.
We will continue to work on QIS-4 questions. We have
strengthened Basel II in the NPR, and I would note that some of
the things that we have strengthened, the Basel Committee in
QIS-5 also noted as areas that need further attention by the
Basel Committee. And so many of the things we already have put
in our NPR I think create timing differences and will be
addressed on a global basis as the regulators worldwide work to
completion of the Basel II.
Finally, I would say, as the central bank, the Federal
Reserve has responsibility for maintaining stable financial
markets and ensuring a strong financial system, and that
mandates that we require banking organizations to operate in a
safe and sound manner with adequate capital that appropriately
supports the risks they choose to take.
And for that reason, the Federal Reserve will continue to
work to make sure that Basel II is implemented in an effective
and safe and sound manner.
Thank you.
Chairman Shelby. Thank you, Governor Bies.
Director Reich.
STATEMENT OF JOHN M. REICH, DIRECTOR,
OFFICE OF THRIFT SUPERVISION
Mr. Reich. Thank you, Chairman Shelby. I appreciate the
opportunity to present the views of the Office of Thrift
Supervision. I feel compelled to state that I began my banking
career 42 years ago, in 1964, and I grew up with a generation
of bankers who believed in two principles: one, you cannot have
too much capital; and, two, you cannot have too much in loan
loss reserves. And I hold those principles today as a member of
the banking regulatory----
Chairman Shelby. I think you are a wise man. We all do.
[Laughter.]
Mr. Reich. When I testified before this Committee last
year, I reported on the progress with the other Federal banking
agencies on the development of the Basel II Framework,
including the then recently completed QIS-4. At the time, I
noted that a number of the concerns with the results of QIS-4.
This week, the agencies are publishing an NPR on Basel II. I
believe the NPR addresses a number of the issues that are
raised by QIS-4, but questions obviously remain, and there is
still work to be done between now and full implementation
scheduled for 2012.
I do believe the addition of various prudential safeguards
that are included in the NPR go a long way toward ensuring the
safety and soundness of Basel II in the United States.
Challenging policy issues remain, and we are committed to
working to resolve these issues based on comments received and
to be received from the industry and other interested parties.
I believe that our longer implementation period in the United
States will provide the opportunity and the time to make
whatever changes are necessary to implement Basel II, but this
is in part predicated upon our receipt of ample and detailed
comments from institutions that may be directly or indirectly
affected by the proposal.
In my written statement, I detail the various challenges
presented by the Basel II Advanced or models-based approach.
While this approach attempts to level the playing field for
banks around the world and provide a more accurate system of
bank capital based upon risk, it is also complex and costly to
implement, and it presents a number of policy and operational
hurdles.
As we develop a more sophisticated risk-based capital
framework, it is also important that we consider the
Standardized Approach, the less complex alternative to the
Basel II models-based approach.
The Basel II NPR requests comment on this alternative, and
I believe it is important for the Federal banking agencies to
consider whether a Standardized Approach could achieve a number
of the same goals as the models-based approach, but at a lower
cost and with greater clarity and transparency.
A critical aspect of the Basel process for U.S. regulators
is ensuring that Basel II rules do not competitively
disadvantage U.S. institutions that may choose to continue
operating under the Basel I-based approach. In addition, to
address competitive equity concerns, as well as to modernize
capital rules for institutions other than the core institutions
that are expected to operate under Basel II, the banking
agencies are also working on modernizing the existing Basel I
rules, and we expect to release the Basel IA NPR in the near
future.
Before my time as the Director, OTS was an early advocate
of comprehensively revising and modernizing Basel I. We
strongly support amending the existing Basel I standards
simultaneously or in close proximity to Basel II to improve the
risk sensitivity of the current capital framework without
unduly burdening affected institutions.
Finally, while Basel IA is intended to increase risk
sensitivity and minimize potential competitive inequities from
Basel II, many highly capitalized institutions have indicated
that they will likely prefer to continue operating under the
rules of Basel I. I am particularly dedicated to the
proposition that we should not unduly burden these
institutions, and I support this flexibility consistent with
balancing safety and soundness with regulatory burden concerns.
The Federal banking agencies anticipate issuing the Basel
IA NPR within the next month, and as with the Basel II NPR, we
encourage comment on the flexibility of this system operating
parallel with Basel and Basel II-based standards.
OTS supports the goals of Basel II, and we are prepared to
make whatever changes may be required during the next few years
of transition in order to make Basel II work satisfactorily for
U.S.-based institutions. We look forward to continuing the
dialog on Basel II and the parallel implementation of the Basel
IA rulemaking, and we will continue to work with this
Committee, with the industry, and with our fellow Federal
banking regulators.
Thank you.
Chairman Shelby. Ms. Taylor.
STATEMENT OF DIANA L. TAYLOR, SUPERINTENDENT OF BANKS, NEW YORK
STATE BANKING DEPARTMENT
Ms. Taylor. Good morning, Chairman Shelby, Ranking Member
Sarbanes, and distinguished Members of the Committee. Mr.
Chairman, before I begin my oral statement, I would like to pay
tribute to Senator Sarbanes for his many dedicated years of
service on the Senate Banking Committee. Senator Sarbanes has
been a wonderful person to work with. He has been a true friend
to the States and a staunch protector and defender of States
rights, and we will miss him.
Adoption of Basel II clearly has potential domestic
implications that could affect our banking system and our
economy. Specifically, we must understand the impact of these
regulations on safety and soundness and competitive equity.
CSBS is fully supportive of the original objectives and
goals of Basel II to better align regulatory capital
requirements to underlying risks and to provide incentives to
banks to hold lower-risk assets in their portfolios. However,
the changes that would be implemented by Basel II must be well
understood and must not have unintended consequences that may
prove harmful to our valuable banking infrastructure which has
served us so well for so many years.
Therefore, before we decide to move ahead with the
implementation of Basel II's Advanced Approaches, I believe we
need to address a number of important issues.
First, the results of QIS-4 in the United States showed a
drastic drop in required capital. My fellow State supervisors
and I have traditionally been vigilant with regard to capital
requirements because of the pivotal role capital plays in
ensuring safety and soundness and in stimulating economic
growth. It is our responsibility to ensure that changes in
capital requirements are prudent, do not unduly benefit one
type of bank over another, and that any transition to a new
calculation of capital is carefully managed. In fact, a major
concern of mine as a State banking supervisor is that if Basel
II goes into effect as currently constructed, the result could
be a further erosion of the dual banking system and our
Nation's broad and diverse financial industry.
Second, in order to successfully implement regulations such
as Basel II in the United States, I believe State supervisors
must have a more substantive role in the drafting and
implementation process. We are very appreciative of Governor
Bies' willingness to provide regular briefings to State
supervisors on the status of Basel I and Basel IA. However,
despite our status as the primary supervisor for most
institutions, we have not been included in the drafting process
of either Basel II or the Basel IA NPR.
Third, CSBS is pleased with the inclusion of several
safeguards that have been incorporated into the Basel II NPR.
Primarily, the maintenance of the current leverage ratio is
crucial in preserving safety and soundness in the domestic
banking system. We commend Chairman Bair for initiating a
dialog on the need for an international leverage ratio. This
would be a significant step to strengthening the international
banking system.
I am aware of the criticism of the so-called conservativism
of the U.S. approach to Basel II and the concern about
international competitiveness. I do not believe we should be
basing competitive equity on reduced capital. Also, this is an
unfounded criticism. U.S. banks currently hold more capital
than international institutions, yet our banks are generally
more profitable than their international counterparts and
remain highly competitive.
I agree that our banks must remain internationally
competitive, but our first priority must be preserving the
safety and soundness of the system and then ensuring a level
playing field for our domestic institutions.
We now have the opportunity and the responsibility to make
sure that when Basel II is implemented in the U.S. it will meet
the objectives first put forth in 1999. I propose that we
consider simpler Basel II options until we better understand
the consequences of adopting Basel II's Advanced Approaches.
Therefore, CSBS recently requested that the Federal agencies
seek public comment on offering the Standardized Approach in
the United States. The agencies have included such a question
in the Basel II NPR, and we commend them for doing so. In my
opinion, it is possible that adopting the Standardized Approach
could allow us to increase the risk sensitivity and
comprehensiveness of current risk-based capital requirements
and establish uniform capital requirements across all
institutions. Our domestic financial system could benefit from
a less complex, more risk sensitive approach to monitor risk-
based capital requirements.
Ultimately, the intention of Basel II is to produce a
stronger international system that does not weaken our domestic
dual banking system. The objectives put forth in 1999 must be
met as we implement Basel II in the coming years. In our rush
to improve safety and soundness and competitive equity in the
international system, we absolutely cannot afford to weaken
safety and soundness and competitive equity in our domestic
institutions. As U.S. regulators, our first priority must be to
our domestic institutions.
I commend you, Chairman Shelby, Ranking Member Sarbanes,
and the distinguished Members of the Committee for addressing
this matter. On behalf of CSBS, I thank you for this
opportunity to testify, and I look forward to any questions.
Chairman Shelby. Thank you.
I will address this first question to Chairman Bair and
Governor Bies. For capital requirements to be effective,
regulators must have a reasonable approximation of what the
proper level of bank capital should be. Using that
approximation, they can then determine whether capital
requirements are too strict or too lax. A key question for
Basel II is whether the expected declines in capital will leave
U.S. banks undercapitalized.
Would you comment, starting with you, Ms. Bair, on whether
U.S. banks are sufficiently capitalized at the present time or
whether they are over- or undercapitalized? And then explain
how you arrive at your conclusion. And how confident are you
about what capital levels will be under Basel II? Do you have
an estimate of the number of Basel II banks whose capital will
fall enough to hit the floors of the Basel II NPR?
That is a mouthful.
Ms. Bair. A long question. [Laughter.]
Well, I am very comfortable with current capital levels,
yes, and I would repeat----
Chairman Shelby. Do you believe that our banking system is
in good shape today?
Ms. Bair. Absolutely. The banking sector is healthy. All
indications are that it continues to be healthy, even though we
are seeing some softening in certain areas. I think our capital
standards are relatively high vis-a-vis other non-U.S.
jurisdictions. That plays a crucial role in the health of our
banking system.
I would like to note, when Basel--I was not around when
Basel II started, but going back and reading the materials of
the Basel Committee itself and its pronouncements, consistently
you will see that the Basel II process was not supposed to be
about lowering capital. It was supposed to be about making the
risk-based capital framework more risk sensitive, not about
lowering capital. So it is frustrating to me--go ahead.
Chairman Shelby. But the lowering of capital has gotten
into the equation.
Ms. Bair. It certainly has.
Chairman Shelby. OK.
Ms. Bair. That is a frustration to me because I see a
healthy banking sector now, one that has been healthy for many
years, and I see, as others have testified, banks, if anything,
hold higher capital than their regulatory requirements. So it
does not immediately suggest to me that banks themselves think
their capital is too high.
I think going forward the QIS-4 results were very
troublesome. We do not know if QIS-4 is an accurate predictor
of what will actually happen under the Advanced Approaches.
Some analysis suggests that actually the capital requirements--
the risk-based capital requirements--could be even lower than
suggested by QIS-4. It requires a lot more analysis.
If we go by the QIS-4 results, though, most of the banks
participating in QIS-4 would be considered to be
undercapitalized if that was the only constraint setting their
capital. So, yes, I think that is why all the regulators viewed
QIS-4 as unacceptable and why we need a lot more work and
analysis before we know whether this is going to work or not.
Chairman Shelby. Do you have an estimate of the number of
Basel II banks whose capital will fall enough to hit the floors
in the Basel II NPR?
Ms. Bair. I do not know the number off the top of my head.
We could provide it for you.
[The information follows:]
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Chairman Shelby. Can you do that for the record?
Ms. Bair. The QIS-4 participants, which included both core
and opt-in banks, most of them would have been below PCA
levels.
Chairman Shelby. Governor Bies, do you have any comments in
that area?
Ms. Bies. Well, let me start by echoing what Chairman Bair
just said, that none of the regulators would have accepted the
state of the databases and models for any of the banks that
participated in QIS-4.
Having said that, as we got in and looked at the QIS-4
information, we really did find areas where either the models
as we had defined them in our regulatory framework or where the
banks were in the stage of implementation made us want to
include additional safeguards in the NPR to strengthen capital
in a few areas. And we have done that in this NPR. And there
are a lot of other areas that we hope to get some input on.
One of the interesting things is that, in the discussion
about how much capital can drop under Basel II, it is important
we differentiate between regulatory minimum capital and actual
or total capital that banks hold. Today, banks hold way above
regulatory minimums because they are driven more by the
marketplace and the rating agencies and other investors who
also require strong capital. So there is more than one
constituency here in terms of looking at total capital.
So it is not clear to me, no matter what minimum regulatory
capital does, how much that will affect banks' actual capital.
But we want to make sure, as we work through this, that
there is enough capital for the different risks, both in this
NPR and in----
Chairman Shelby. Well, that is the basis of a sound banking
system, is it not?
Ms. Bies. It is. And one of the challenges we have is the
banks use economic capital models internally that are very
similar to what we have specified. The big difference is the
banks use them to manage their strategy. Long run, where are
they going? What is the kind of variation they are likely to
encounter? But as regulators, we want capital to be there when
the banks come under stress, and so we tend to focus on
downturn events and more of the tail losses than the banks do
in their internal models. And that is one of the reasons we are
asking for more capital--that is, higher minimum regulatory
capital--than many of them have in their internal models.
Again, the comments we hope to get on the Basel II
framework will help strengthen that, but we want to make sure
we are comfortable that the capital is there in those stress
periods.
Chairman Shelby. Governor Bies, Senator Sarbanes brought
this up a few minutes ago. But former FDIC Chairman William
Isaac, who is well respected in the banking area, has raised
serious concerns about the reliability of the data that banks
will collect and compute to determine their capital
requirements understand Basel II's Advanced Approach. In prior
testimony to this Committee, former Chairman of the FDIC Isaac
noted that banks do not have loss data going back far enough
and that mergers and acquisitions in the banking industry have
left banks without consistent data.
To what extent, Governor Bies, will these problems with
data collection--knowledge, in other words--undermine the
effectiveness of Basel II's Advanced Approach? Have you taken
this into consideration? And, if not, will you?
Ms. Bies. We are taking it into consideration. It is one of
the things that we spent a lot of time analyzing in the QIS-4
results and our foreign counterparts did in QIS-5.
When we look at the capital, we know that all of these
models are providing estimates. Banks also are creating new
products all the time, and one example would be the new
mortgage products that some of us are very concerned about that
the banks are underestimating risk. But that is why I emphasize
that Pillar 2----
Chairman Shelby. Mortgage products with no downpayments,
all those kind of things.
Ms. Bies. Those negative ams and payment shocks and all
those wonderful bells and whistles.
Chairman Shelby. That should keep bank regulators up at
night.
Ms. Bies. It keeps us awake at night, and that is why
Pillar 2 is so important. It allows us as supervisors, where we
feel either it is a new product, the model is not reliable, or
it has a kind of risk that the Pillar 1 does not pick up--
because Pillar 1 does not pick up all risk. We can specify
additional capital the banks have to hold beyond their Pillar 1
numbers.
Chairman Shelby. Chairman Bair, I am not picking on you.
Ms. Bair. That is all right.
Chairman Shelby. You just have a big portfolio here. All of
you do. But in your testimony, you call for considering an
international leverage ratio as a way to eliminate the
competitiveness concerns presented by the retention of the
leverage ratio under Basel II, as well as a way to improve
global capital standards.
Could you discuss with us the idea here a little further
today and whether foreign regulators would be receptive to the
idea?
Ms. Bair. Thank you, Mr. Chairman. Yes, the leverage ratio
is obviously a very simple capital-to-assets ratio. There is no
cost to implement it. It is a hard number; it is an easy-to-
determine number.
We have had many years' experience with it. It has worked
very, very well for the banking system. Canada is the only
other country that has something like a leverage ratio, and the
way they calculate theirs is a little different from ours. But
I have been engaged in conversations at the staff level and at
the principal level with other Basel country members and their
representatives. I will be going to Mexico next week for the
next Basel Committee meeting and hope to be talking more and
will be formally pushing to have an international leverage
ratio put on the agenda.
Some responsiveness, some reluctance, a lot of reticence.
This obviously is new--not a concept that has been embraced
heretofore. But, I think particularly as we look at the
potentially dramatic drops in risk-based capital under the
Advanced Approaches as we are moving forward, and it is not
just U.S. banks that are seeing this, that that can make the
leverage ratio more attractive as a hard baseline.
We are not sure we are getting it right with the Advanced
Approaches. That is why we need more work. We are not sure that
we are actually measuring risk under risk-based capital, and
one of the good things that would occur through the leverage
ratio is to give us a baseline, if we are not getting it right,
at least providing a floor under which capital could not drop.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Well, thank you very much, Mr. Chairman,
and I want to thank the panel. I know you summarized the
statements, and I have been through the statements, and I
appreciate the time and effort that obviously went into them.
Chairman Bair proposed that we negotiate an international
agreement to establish a common leverage ratio in her
testimony. In the next panel, Professor Tarullo supports that
concept with the recommendation that it includes off-balance-
sheet activities as well.
The first question I want to put: Is there anyone at the
table who holds the position that the United States should not
continue to require the leverage ratio? I take it everyone
takes the position that we should require the leverage ratio.
Is that correct?
All right. Now, if we continue the leverage ratio, is there
any reason not to seek an international agreement on a common
leverage ratio? What is the argument, if any, against at least
undertaking this initiative? Basel I, after all, as I recall,
was an effort to raise the amount of capital in the
international banking system, which, of course, is a very deep
concern of ours. And Professor Tarullo in his statement, which
is coming later in the morning--I would like to get these up in
front of you, because you all testify and then you up and go
away, and then these other folks come on, and they make these
statements, and we do not have you here to sort of respond to
them. So I am trying to get the horse ahead of the cart in this
respect.
He says, ``The last thing many Basel Committee members want
to do is to return to negotiations over international capital
standards. Understandable as that sentiment may be, I would
nonetheless urge our banking agencies to use the breathing
space created by adoption and implementing regulations for
Basel II to pursue alternatives both domestically and
internationally. The problem with the A-IRB approach more than
justified this response. At this juncture, the most promising
approach may be a relatively simple international minimum
capital rule accompanied by complementary domestic measures for
achieving appropriate bank risk management and by enhanced
international cooperation supervising complex, multinational
banks. Specifically, I would suggest that the banking agencies
raise with the Basel Committee the idea of an international
minimum leverage ratio.''
Then he recognizes that it is a simple rule that does not
necessarily address all the complexities, but he says,
``Because of its very simplicity, it is far more transparent in
its application, far less easy to manipulate than more complex
regulatory capital requirements. It can serve, as it does today
in the U.S., as a useful warning sign to regulators and
markets. Its application could be fairly easily monitored
domestically and internationally.''
So I come back to my question. If you all believe we should
have the leverage ratio, is there any reason not to seek an
international agreement on a common leverage ratio? Mr. Dugan,
why don't we begin with you and go right across the panel.
Mr. Dugan. Sure, Senator. Chairman Bair has put this issue
on the table, but it is not one that we have had a chance to
meet on as a group and discuss.
You have stated the issue quite well in terms of our being
committed to the leverage ratio in the United States. It has
worked well here. Just by way of background, other regulators
have not imposed a leverage ratio in their countries and in the
past have been quite adamant, in many cases, about not
believing it is appropriate.
I think the concern that some of us have had is if this
gets put into play internationally, what is the tradeoff? What
is the potential price that we would have to pay in such a
negotiation? How would such a leverage ratio be computed? Would
there be a risk that our particular leverage ratio would be
decreased as a matter of international harmony? Because, after
all, the Basel Committee is not and never has been intended to
result in identical capital requirements set by an
international standard body. There has always been an element
of national discretion. And, while we prefer the leverage ratio
in our country, there are other aspects of the Accord that
other countries prefer that we do not like. I would want to see
what the entire package was before committing to it. I think
those are the kinds of concerns that we need to think about as
we discuss this issue.
Senator Sarbanes. Are those concerns so weighty in your
mind that you would not even put it on the table for
discussion?
Mr. Dugan. I think that is the discussion we ought to have
as an interagency group. We really have not had any serious
discussion about the pros and cons, and I would like to have
that discussion.
Senator Sarbanes. Ms. Bair, I already know your position,
but go ahead.
[Laughter.]
Ms. Bair. Well, I would be happy to have anytime, anywhere,
even more discussions on this. I think it is very hard to argue
against at least having a debate on something. And I think we
all agree that any discussion of eliminating the leverage ratio
is off the table domestically. I hope the representatives of
the large banks sitting behind me that are concerned about
competitive disparities and treatment are listening to that,
because they are going to have a leverage ratio here in the
United States. So it seems to me that if people are worried
about competitive disparities, frankly, I am more worried about
liquidity and stability in the global banking system,
particularly if we see further declines internationally in
risk-based capital, which right now is the only constraint for
the vast majority of Basel countries. So I think getting it on
the table, at least forcing people to talk about it, is very,
very important. We can control where it goes. I am not going to
make any significant concessions on our own standards to get
the debate going, but I think that we do need to have the
debate. And since we are starting with a zero baseline for most
Basel countries since they have no leverage ratio, anything we
can get them to do is going to raise the bar up in those
countries.
Senator Sarbanes. Ms. Bies.
Ms. Bies. Senator, I think we should raise the issue at the
Basel Committee. As Mr. Dugan just commented, this has been
raised before at other periods, and other countries have been
very vocal against the idea.
I think one of the challenges we will have is the legal
framework in different countries in terms of the kind of
activities that go on within a bank varies, and that is why we
have made more progress using a risk-based framework where
similar activities are treated similarly. We would have to
anticipate how to deal with that issue because that is sort of
the heart of each nation's ability in terms of powers within
the banks.
Senator Sarbanes. Mr. Reich.
Mr. Reich. Senator, when OTS has a seat at the Basel table,
I will be happy to join Chairman Bair in advocating for an
international leverage ratio.
[Laughter.]
Senator Sarbanes. OK. Fair enough.
Ms. Taylor.
Ms. Taylor. Ditto, Chairman Reich.
Chairman Shelby. Senator Carper.
STATEMENT OF SENATOR THOMAS R. CARPER
Senator Carper. Thanks, Mr. Chairman. To our witnesses,
welcome. It is good to see you. Thank you for joining us today.
I do not know if my Chairman and Ranking Member have ever
used this before, but a lot of times issues come before us, and
we are divided. We are not sure really how to go, and
oftentimes we will see some of my friends are for it, some of
my friends are against it, and I am for my friends.
In reading through my briefing materials for this hearing
today, it looks like some banks, including some banks that have
substantial operations in Delaware, are for this and some are
not. And I understand we are starting a 120-day comment period
so that everybody can weigh in and say what they believe is
good or bad about this?
Do I understand that there are about 20 banks in this
country that would be affected? Is that correct?
Mr. Dugan. There are about a dozen core banks that, as
proposed, would be mandatory, and then there is another group
of banks that has talked about opting in.
Senator Carper. And it is their choice, opt in or opt out?
Why would they opt in as opposed to opting out? What is the
rationale for that?
Mr. Dugan. I think the rationale is that the Advanced
Approaches are viewed as a more sophisticated system that
address for large banks the kinds of risks that they would be
involved with anyway. The notion is--and we heard this actually
with the securities firms that testified on the other side--
that it is a measure and an indicia of being a large,
sophisticated player. If it became a standard, large banks
would get measured against it, and they want to rise to that
level, assuming it is a more rigorous way to measure risk in
the system.
Senator Carper. For the banks, especially American banks, I
understand there are three or four that really like this
approach, and some that are less enamored with it. But for the
ones who really think this is the right thing to do, what--I
think I understand the rationale, but what is it?
Mr. Dugan. I think the idea is that there is support for
tying capital more closely to risk--that is how they do it
themselves--and a recognition that the current system is not a
very good measure of that. Among other benefits, if there were
a common way that it was done, regulators would understand
better how this was computed, and there would be disclosures to
markets that would reward banks that had a less risky profile
according to the risk-based capital measurements of the
Advanced Approaches. So there are several reasons why
institutions would think this was a positive thing, if it were
done correctly. The devil is in the details, as you will hear.
Senator Carper. All right. Others, please.
Ms. Bies. Senator, I think one of the other issues that we
hear as we talk to banks, not only in the U.S. but globally,
the sophisticated models that banks use to run their shops day
to day are very opaque to the outside world. And what Basel II,
especially the Advanced Approaches, does is give them the
confidence that regulators, in a common framework that we set
out as requirements are confident the bank's measure of risk is
within the range of the expected variance for the risk exposure
and it is done in a consistent way. Today they all do it in
different manners.
The additional disclosures that are required in Pillar 3
compared to what is there today would give users of financial
statements and bank customers and investors better information
about the nature of risk the bank is taking. And as they go
through time and see what real risks are from period to period,
they can look at how reliable the bank's risk management
practices are and how well they anticipate the kinds of
situations that could create loss for that organization.
Senator Carper. Among the 12 or so banks that will be
directly affected--they do not have a choice; they are going to
be in whether they opt in or not--the folks that are less
enamored with this approach, what are they saying? What are
their concerns? Are they legitimate?
Mr. Reich. Too costly, too burdensome; that the regulators
have added some safeguards which make it less conducive, less
beneficial to them.
Senator Carper. So it is burdensome, it is costly, it is
not beneficial. But other than that, they are OK----
Mr. Reich. Other than that, it is a good thing.
[Laughter.]
Senator Carper. Let us say that you lived in Salisbury,
Maryland, or Foley, Alabama, or----
Chairman Shelby. Tuscaloosa, Alabama.
Senator Carper. Whatever. Or Lewes, Delaware. Why should
you care about this stuff? Why is it important to folks there?
Mr. Dugan. I had an outreach meeting with a group of
community bankers last week, and I think there is a recognition
that the very largest institutions are in a very different
business in many ways from the community bankers, and there is
a concern that if ever there were a problem with a large
institution, it would affect the entire system.
So there is concern, and I get this question all the time:
What are you doing to make sure you have your arms around the
complex risks that the largest institutions take? And one of
the answers, one of the fundamental reasons we are trying to
get Basel II right, is because it is an opportunity to move
toward a more sophisticated approach and to enhance risk
management in a way that allows us to look across our largest
institutions to help ensure that they operate in a more safe
and sound manner, given the very different and very complicated
types of risks that they take as they perform their function in
the economy.
Senator Carper. Ms. Bair, do you want to add anything to
that?
Ms. Bair. Yes, I would, because I think we all agree that
complex banks need complex risk management tools. The question
is whether you tie that to capital reductions, whether you use
capital reductions as an incentive or whether under our
supervisory powers, the banks under our jurisdiction, we ask
them to have risk management systems that are conducive to
their business model. So I think that is really where the issue
is, not with regard to whether complex banks need complex risk
management tools.
Also, in the sense that these models that we are requiring
banks to implement in the Advanced Approaches are giving us
accurate--complex as they are--risk measurements, that is a
very, very key question. The QIS-4 results showed that there
were wide dispersions in how large banks were measuring risk
for identical exposure. So that suggests to me that these
complex models need a lot more work before we can have
confidence that they are really giving us precise measures that
might justify reductions in capital.
Senator Carper. My time is expired. Can I just ask one more
quick question?
Chairman Shelby. Go ahead.
Senator Carper. After 120 days goes by and people have had
a chance to comment, what happens?
Ms. Bair. We will all come together and make a decision.
[Laughter.]
I would say I want to pay tribute to Sue Bies in particular
for the leadership she has shown and her knowledge on this
issue. And as you can tell, we have differing perspectives,
different emphasis, different questions. But I think everybody
has worked together very collegially to try to come together.
We did it with the Basel II NPR. We are doing it again with the
Basel IA NPR. And I think when we go to final rulemaking, it
will be that same collaborative spirit.
Senator Carper. All right. Thanks.
Ms. Bies. I would just like to add that, you know, we will
be coming out next month with the Basel I NPR, and so both the
Basel II and Basel IA NPRs will be out for comment, because we
also care about the competitive issues within the U.S. banking
system. So we want to look at all the comments from both
proposals and look at how they fit together and see if we have
struck the right balance and have addressed the concerns of
banks of all sizes, and that we end up with a strong capital
framework going forward.
Senator Carper. Great. My thanks to each of you.
Thanks, Mr. Chairman.
Chairman Shelby. Thank you.
I think this is a very important hearing, not just for you,
the panel, but for us and the public. I will direct these
questions to Comptroller Dugan, Director Reich, and
Superintendent Taylor.
Basel II will not only impact the large banks that adopt
it, but also smaller banks that will have to compete with those
Basel II banks that will then have different and possibly lower
capital requirements. Will the significant up-front costs
necessary to qualify to use Basel II serve as a barrier, Mr.
Dugan, to entry that will prevent banks from growing and
becoming large enough to qualify for Basel II? In effect, will
Basel II cement the position of the largest U.S. banks and give
them a competitive advantage over all other banks?
Community banks are especially concerned about how Basel II
will impact them. Could you please comment on the steps that
you have taken both to address the competitiveness issues
between Basel II banks and community banks and to address
concerns that Basel II will reduce loans to small businesses,
which could have an impact on our economy? Are there additional
measures necessary?
We will start with you, Mr. Dugan.
Mr. Dugan. Thank you, Mr. Chairman. That is exactly why we
are putting Basel IA out for comment. You are right, it takes a
very substantial investment in order to qualify for Basel II,
and ordinarily that would be out of reach for community banks.
So the question is: In the way that Basel II is structured,
does it create a competitive imbalance that is serious enough
that we have to worry about ways to address it? We are
concerned about that, and Basel IA is an effort to address some
of those issues. I cannot say it is going to be an identical
rule. If it were, we would have Basel II all over again. The
question is: Have we struck the right balance there?
In terms of small business lending, there was a proposal in
the international version of Basel II that created a specific
capital break, if you like, for small business lending that we
did not include in the notice of proposed rulemaking for Basel
II precisely because of this capital question. But the
comparison between that treatment in Basel II and Basel IA is
exactly why we need to put this out for comment and hear from
people, and why we have been advocating an overlapping comment
period so we get both sets of rules on the table before we get
to the decisions of how to go final on both proposals.
Chairman Shelby. Director Reich.
Mr. Reich. Well, I am very concerned about the impact on
community banks with the changes that are being proposed, and I
will be vigilantly defending and looking out for the interests
of community banks as we go forth with Basel II and Basel IA
and Basel I.
One of my greatest fears at the outset a few years back
about Basel II is that it might result in accelerated industry
consolidation and the disappearance of community banks from the
scene. I do not want to see that happen.
Chairman Shelby. Could that have an adverse effect on our
job creation machine, small business?
Mr. Reich. Absolutely. It would have tremendous social
costs to local communities.
Chairman Shelby. Ms. Taylor.
Ms. Taylor. Once again, I want to say ditto to Chairman
Reich. I agree with everything that he said. I am very
concerned about the competitive imbalance, potential
competitive imbalance between the very large banks which take
the advanced IRB approach as opposed to the smaller banks. And
I am very happy that the two comment periods for Basel II and
Basel IA are overlapping.
Chairman Shelby. I have a number of questions here for
Governor Bies and Comptroller Dugan, and you might want to do
this for the record, but we would like to have this
information.
We would like to better understand your agencies' decision
to request comments in the Basel II NPR on whether banks should
be allowed to choose the Standardized Approach. Your agencies
had previously decided that Basel II banks would only be
allowed to use the Advanced Approach.
So my question is: Why did your agencies originally decide
not to allow banks to use the Standardized Approach? Second,
why have you now decided to re-evaluate this decision? And,
third, what factors will you consider when deciding whether to
allow banks to use the Standardized Approach? Given that Fed
Chairman Ben Bernanke, during his last appearance before this
Committee, expressed concerns about whether the Standardized
Approach is appropriate for large global banks, is the
Standardized Approach a realistic alternative for our biggest
banks?
You might want to do that for the record. Do you want to
comment on it now?
Ms. Bies. Let me just make one----
Chairman Shelby. Because this is a mouthful here.
Ms. Bies. Right. I would like to do a written comment, but
let me just put one thing in perspective.
When we chose to go with the core group of banks, about a
dozen, we were focusing on the complex organizations. The
complex organizations, we feel, need some risk framework that
reflects the kind of positions they are taking, the
sophisticated instruments they are using. But the comment
letters and requests that we recently got come from small
organizations, too. And the Standardized Approach, as I have
commented on, is in Basel II for the countries who no longer
have Basel I for their smallest organizations.
So the way the questions are teed up, you will see the way
Basel IA is teeing it up, to ask how could a Standardized
Approach be used, and for what institutions is it appropriate.
And we want to hear comments on this because if we want to
change direction we want specific input--that is why we are
still in the comment period.
Chairman Shelby. Would you give us a comprehensive answer
on that for the record? Because our staff and all of us would
like to closely look at that.
Mr. Dugan. Mr. Chairman, if I could just add one point
briefly?
Chairman Shelby. Yes, go ahead.
Mr. Dugan. We will be happy to provide an answer for the
record. The Standardized Approach, the one that was adopted for
the international community, has some hard risk weights that
raise some concerns about whether they would be appropriate in
the United States, and we will have to look at what would be an
appropriate version in the United States if we were going to go
down that path. That is exactly what we will be asking
questions about in Basel IA, and I think that is appropriate.
Chairman Shelby. Ms. Bair.
Ms. Bair. I would just say I think that is a very central
question, and I think key to that debate is input on, again,
whether we see the need for further complex risk management,
whether that can be done under Pillar 2 supervisory authorities
or whether it has to be tied to capital levels.
Chairman Shelby. I will direct this question to Governor
Bies and Comptroller Dugan. How will your agencies monitor the
implementation of Basel II Advanced Approach by foreign
regulators?
Second, given that the implementation of Basel II will be
opaque to anyone outside the banks and the regulators involved,
what assurance does this Committee and, more importantly, the
public at large have that Basel II will be implemented
properly? Governor Bies.
Ms. Bies. Well, first in terms of----
Chairman Shelby. Because there is a lot of difficulty here.
You have all said that.
Ms. Bies. Yes, and we have been working very hard at this
with our staffs now for a couple years.
The Basel Committee a couple years ago created the Accord
Implementation Group that has been working under the leadership
of Nick Le Pan, who heads the Canadian bank supervisory
authority, to work out answers to exactly the question you are
asking: How do we work internationally to get to as much
comparability as we can get? Internationally, you never get
exactly the same treatment. But we want to identify how we are
going to rely on each other and how, what we call our home host
issues will be addressed.
In addition, for the global banks--and luckily we are only
talking about 50 or so that really create a lot of countries'
involvement--where they are in multiple countries across the
globe, we actually have created a college of supervisors around
that unique institution where we already are in a couple cases
testing out what are the biggest issues, how would we deal with
it, how would we implement it in different countries given
different legal, national requirements, and then look at the
consolidated entity. So we are heavily into this, in part
because Europe, as you know, goes live in January 2007 for
Basel II. So we are far along in this.
In terms of opaqueness, when we issued the NPR this week,
there are also some templates for additional data disclosures.
Some of these will be made public because call report data
today does not reflect risk-taking the way we need to for these
complex activities.
There is also some additional information that will be
gathered by the regulators and kept confidential that will
allow us to look across organizations at comparability.
The public part of it we think will greatly give more
transparency to the risk-taking of each of these organizations
compared to what we provide today through today's call report
definitions.
Chairman Shelby. Ms. Taylor, I would like to direct this
next question to you, if I could. State banking regulators
oversee the vast majority of our Nation's financial
institutions. Hence, Basel II and especially Basel IA will
directly affect not only the safety and soundness of the
institutions that State banks regulate, but also how State
banking regulators oversee State banks.
What has been the role of State banking regulators in the
process for developing Basel II and Basel IA? Have you or other
State banking regulators been included at all in the drafting
process for the regulations? And if not, is there a mechanism
through which your input is taken into account by Federal
banking regulators?
Ms. Taylor. No, we have not had a seat at the table.
Chairman Shelby. You have not been consulted, basically,
have you.
Ms. Taylor. No. We have been briefed on what----
Chairman Shelby. Briefed? There is a lot of difference
between briefing and being consulted.
Ms. Taylor. Yes, sir.
Chairman Shelby. So you have not really had any input into
this process, have you?
Ms. Taylor. No.
Chairman Shelby. Thank you.
For the entire panel, and, Governor Bies, I will start with
you, and maybe you can answer it for everybody. Where are we in
the process with respect to hitting the expected starting date
of the Basel II parallel run in 2008? And would delay of
implementing Basel II have any implications for the
competitiveness of U.S. banks and on the safety and soundness
of our banking system?
Ms. Bies. Well, obviously, it is hard to anticipate what
all the comments are going to be around Basel II, and I think
the real issue is going to be how close we are in the NPR to
what the commenters would like us to end up with. If we hear
major changes in the comments, it could create time pressures
because we clearly have to get the final rule out for banks to
have enough lead time to start and be ready for the parallel
run in January of 2008. I think we really need to see what the
comment letters are, but it is a very tight timetable that we
are under right now.
In terms of internationally, that could create some
transitional issues. But, again, the AIG recognizes that
different countries are moving at different paces. Some
countries actually are moving ahead of the mid-year agreement.
So some are further along already than we are. So we have been
anticipating the transition issues. Further differences in
timing will make those last longer, and it could create some
longer-term implications. But we already are dealing with
timing issues, and I think the timing issues generally are a
little bit easier to deal with than the permanent differences
that may happen.
Chairman Shelby. Up to this point, a lot of our discussion
here today has entirely focused on the application of Basel II
on domestic firms. Let's just switch the focus for a moment and
ask whether Basel II's reduced capital requirements could hurt
a foreign bank, foreign firm, and the collapse of that firm or
bank could then have a ripple effect that ultimately hurts our
bank or our banking system. You know, the reverse. It is always
possible, is it not, that a large foreign bank under Basel II,
which they have adopted, doing business in a big way in the
U.S., if they got in trouble, it could have a ripple effect,
could it not, Mr. Dugan?
Mr. Dugan. Yes, but the whole point of Basel II is to get
onto a common scheme and to have more harmony in terms of
capital requirements. The effort is to avoid exactly that
result.
Ms. Bair. And I hate to be a Johnny One-Note, but this is
one of the reasons why I think it is very important to get a
debate going on an international leverage ratio, if we are
seeing further reductions in risk-based capital, which is the
only constraint for most Basel countries. We really need to get
a debate going on leverage--another nice thing about the
leverage ratio is that it is a constraint on leverage so it
helps promote liquidity in the global banking system. So I
think your question is very much responsive to the need for an
international standard of leverage.
Chairman Shelby. Governor Bies.
Ms. Bies. Let me just comment on how we deal with
differences in the strength of supervision because we have this
situation today. When a foreign bank has a legal entity in the
United States, where any of us might be the primary supervisor,
we require within that legal entity to hold the same kind of
capital and controls that we would of any domestic bank.
The additional issue, though, is when foreign bank
subsidiaries are part of a global group, they may be branches
here or they may rely on different control systems from the
global group that are not in the United States physically, and
that is where it is so important that we work with foreign
supervisors. The Federal Reserve as a holding company
supervisor looks at the strength of foreign bank supervisor in
what we call our SOSA ratings, and we take that into account,
whether we can rely or not rely on the foreign supervisors and
whether we give that foreign entity the ability to operate in
the U.S. on a level playing field.
We have limited expansion or prohibited expansion by banks
from certain countries where there has not been strength of
their domestic supervision because of the contagion effect of
something happening at their parent company.
Chairman Shelby. Mr. Reich, do you have a comment?
Mr. Reich. Well, I would agree with Chairman Bair that your
question highlights the importance of an international leverage
ratio.
And speaking to another part of your question, I think that
getting Basel II right is more important than deadlines that
currently exist, and if the deadlines need to be adjusted, as
one participant at this table, I am willing to adjust them.
Chairman Shelby. Ms. Taylor.
Ms. Taylor. I think it is important to get it right the
first time when it goes out because it is a lot harder to fix
if it is wrong going down the road than it is to fix now.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Well, thank you very much, Mr. Chairman.
I know you want to get to the next panel.
Chairman Shelby. I think this first panel is important.
Senator Sarbanes. It certainly is. But I am going to try to
be very quick here.
First of all, I want to again quote what I said in my
opening statement, quoting Bill Isaac. ``This is by far the
most important bank regulatory issue in front of us today. If
we get this one wrong, our Nation and taxpayers will almost
certainly pay a very big price down the line--a price that will
make the S&L debacle seem like child's play.''
I agree with that. I think this is a very large issue. I am
deeply concerned how we got down this path without fully
examining a lot of the implications and consequences. It is
interesting to me that four large banks came in now and want to
be able to choose the Standardized Approach, which would, of
course, allow them to go into Europe without a problem, which
is--or to be in Europe without a problem, although you have
that one issue you say you need to pay attention to.
But the consequences here are very large. I mean, we talk
about the effects on smaller banks and small business. Isaac,
who is coming up on the next panel, says, and I quote him, ``We
have already experienced a great deal of consolidation in the
U.S. banking industry, with the 25 largest banking companies
now controlling some 70 percent of the Nation's banking assets.
I am convinced that creating a large disparity in capital
standards between the large and small banks will lead to
increased consolidation, leaving fewer banking choices for
smaller businesses. Further consolidation in banking is
inevitable, but it ought to be driven by market forces, not by
capital rules that favor larger banks.''
And Tarullo, when he appeared here last year, said, and I
quote him, ``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 advanced
rules will become concerned that they will be disadvantaged in
competing with the advanced banks in those lending markets.''
Second, we have talked here--the Chairman I think focused
on it early on, and I think it is a very important issue--about
the data. I mean, models, no matter how sophisticated, are no
better than the data that go into them. The proposed Basel II
rules require that the banks have a minimum of 5 years of data,
but we have not had a serious recession for most lending
activities in 10 to 15 years.
And Bill Isaac, in our hearing last year, said, and I quote
him again, ``Basel II is based on inadequate and unreliable
data. It is virtually impossible to build reliable models with
such a paucity of information, particularly when the decade
that the available data covers is the most prosperous in
banking history.''
I mean, talk about a leap into the unknown. In fact, I am
told that banks are being told to put a recession into their
data if it is not there already. Now, that is an interesting
approach. You know, we are going to, in effect, create a
scenario and try to plug it into the model to cover a
recessionary situation.
Now, let me address this question of the international
competition, that we would be at a competitive disadvantage.
Isaac, in his testimony that is going to come, says, ``It is
argued that large banks from other countries will have a
competitive advantage unless U.S. banks are allowed to use the
advanced modeling approach. I do not buy that argument. The
fact is that U.S. banks are by far the best capitalized, most
profitable banks in the world. They do a great job of meeting
the credit needs of business and individuals and are a major
reason the U.S. has the strongest economy in the world.''
He says, ``Other countries should emulate the U.S. system,
not the other way around. The U.S. should urge other countries
to impose minimum capital standards on their banks, rather than
enabling U.S. banks to lower their capital to unsafe levels.''
Which, of course, goes to this initiative.
Is it not the case that the U.S. already has a higher
capital requirement than those abroad?
Ms. Bair. Yes.
Senator Sarbanes. Now, is it the view of any regulator at
the table that these higher capital requirements have put U.S.
banks at a serious competitive disadvantage?
Ms. Bair. No.
Senator Sarbanes. Well, then, what is it--I mean, we are
constantly hearing this argument being advanced that we are at
a competitive disadvantage, we have got to lower the capital
standards.
We have got the profitability of major banks, percentage of
total average assets. There is the U.S. pre-tax profits, first
on the list. First on the list. We seem to have been able to
have better, higher, more quality capital standards and still
sustain profitability.
In fact, this Advanced Approach would require the banks to
spend an inordinate amount of money to try to develop these
models, would it not? Isn't it an expensive proposition to
develop these models?
Mr. Dugan. Yes, it is, Senator. I do not think any of us
takes the position that there is a competitive disadvantage
because of the higher capital that U.S. banks hold. I think the
issue is which approach will produce a more safe and sound
result for the particular bank.
Senator Sarbanes. All right. Now, here is what Isaac says.
I bet you are all sorry I read this statement ahead of this
witness.
[Laughter.]
``Models are important to large banks in managing banks and
pricing risks. They are a management tool, but are very poorly
suited for use in setting regulatory capital standards.''
Now, the banks develop these models in any event, to some
extent, and would continue to do so, as I understand it.
Mr. Dugan. Senator, that is not quite right. We regulators
have the model, the banks provide the inputs to the model, and
our model then computes the capital charge.
Senator Sarbanes. Isaac says this: ``Nearly every
professional bank supervisor with whom I have spoken believes
the Advanced Approach under Basel II is fundamentally flawed.
Every major industry trade group has requested that the
Standardized Approach be made available as an option.'' And
they go on to talk about its complexity and that no one would
understand it. You know, it lacks transparency and so forth and
so on.
It seems to me that both of these witnesses on the next
panel sort of say, well, look, there is a way to work ourselves
out of this box we are in. You retain the leverage ratio. You
try to get it adopted internationally, which would be a
significant improvement in the capital situation worldwide with
respect to the banking industry. You allow the Standardized
Approach, which has more sophistication than where we are right
now. But you do not get into all of the problems inherent in
going to the Advanced Approach. Yet, as I understand it, some
of our regulators are bound and determined that these major
banks will go into the Advanced Approach with all of the
problems that come along with that.
It seems to me--and I know you all took an initiative. Ms.
Bies, you were in the forefront of that, I guess, and the Fed
pushing down that path, and now it is, I would presume, awkward
in dealing with your international partners to sort of come
along and say, well, you know, wait a second, there are a lot
of implications here and we need to come back and rethink this.
But it seems to me, given the concerns that are being
raised--very reasoned, I think, and rational concerns--that we
need to say, now, wait a minute here, let's re-examine this.
I do not want some leap into the dark. And I do not want to
be told that, well, you know, we can hypothetically do these
models and everything is going to be OK. We have been through
some rough patches up here, and we need to--and at the moment,
we have got high capital standards and we are highly
profitable. That seems like a pretty good combination to me.
Thank you, Mr. Chairman.
Chairman Shelby. Thank you.
Before we move on to the next panel, I want to associate
myself first with some of the remarks of Senator Sarbanes.
While I recognize that the development of Basel II required a
considerable amount of time and energy, I do not think the fact
that such efforts have been undertaken in and of itself
justifies moving forward. We should not adopt Basel II simply
to adopt Basel II. We should adopt Basel II if it is sound
public policy and improves the risk management of our financial
institutions, and ultimately helps our economy.
This Committee is committed to continuing its oversight of
the Basel II process and to making sure that any changes in our
capital requirements are prudent and proper. However, the
complex and technical nature of Basel II means that the
responsibility for the final Basel II regulations falls
distinctly on your agencies that you represent here today. And
I think this is a matter of critical importance. In fact, I
believe that I can say without overstating the significance of
this issue, developing and successfully implemented new capital
standards will be the single most important task that each of
you will undertake during your tenures in your positions.
As you move forward, I would just like to remind you of the
difficult lessons learned--and Senator Sarbanes talked about
it; both of us have been on this Banking Committee a long
time--when thousands of thinly capitalized banks collapsed
during the 1980's and early 1990's. We were here. Therefore,
before you do anything, be sure that what you are doing is
right, that it is the right thing to do.
I want to thank you again for testifying before us, and you
are going to furnish some of the information for the hearing
record.
Senator Sarbanes, do you have anything else?
Senator Sarbanes. No.
Chairman Shelby. We will call up our next panel now: Mr.
James Garnett, Head of Risk Architecture of the Citigroup on
behalf of the American Bankers Association; Mr. Daniel Tarullo,
Professor of Law at Georgetown University Law Center, and no
stranger to this Committee; Ms. Kathleen Marinangel, Chairman,
President, and CEO of McHenry Savings Bank on behalf of
America's Community Bankers; and, of course, Mr. William Isaac,
former Chairman of the Federal Deposit Insurance Corporation,
and now Chairman of the Secura Group.
I want to thank all of you for appearing here today and for
sitting through this protracted hearing.
All of your written testimonies will be made part of the
record in their entirety.
Mr. Garnett, we will start with you, if you can briefly sum
up this before we get a vote on the floor. Your entire written
testimony, as I said earlier, will be made part of the record.
STATEMENT OF JAMES GARNETT, HEAD OF RISK ARCHITECTURE,
CITIGROUP
Mr. Garnett. Thank you, Sir. Chairman Shelby, Ranking
Member Sarbanes and members of the Committee, my name is Jim
Garnett. Thank you for the opportunity to testify today.
I am responsible for the implementation of Basel II for
Citigroup. I am here today on behalf of the American Bankers'
Association. The ABA has long supported capital reform and
remains committed to the implementation of Basel II in the
United States.
Unfortunately, the Basel II proposal published yesterday by
the Federal banking agencies would place U.S. banks at a
competitive disadvantage with foreign competitors and would
impose significant compliance costs on U.S. banks.
These problems are due to differences between the proposed
U.S. version of Basel II and the internationally approved Basel
Accord. U.S. regulators have proposed provisions that reduces
the risk sensitivity of Basel II and do not apply to foreign
banks. These include, for example, longer transition floors,
different definitions of default and special capital
restrictions triggered by all Basel II banks in the aggregate.
These new features which apply only in the U.S. frustrate
the goal of aligning risk and capital and thus fail to create
appropriate incentives for risk-taking. Therefore, we recommend
that the U.S. version of Basel II be harmonized with the
international accord. Doing so would better align risk in
capital. It would prevent foreign banks from gaining a
competitive advantage over U.S. banks and it would reduce
compliance costs for U.S. banks.
Moreover, to attain competitive balance within the American
banking industry domestically, an appropriate update of capital
rules is needed for all of the community and regional banks for
which the more advanced elements of Basel II may not be
appropriate. We also recommend that U.S. banks be given a
choice of capital compliance options, giving all American
banks, large and small, a choice of options has several
benefits. Choices consistent with the international accord.
Choice gives banks of all sizes access to simple and
transparent methods for capital compliance. Choice assures a
competitive domestic marketplace and choice reduces compliance
costs.
The compliance options might include Basel I, Basel IA, the
Standardized, and Advanced. The Standardized Approach in
particular is transparent and cost effective. It ties capital
charges to factors such as credit rating of the borrower and
strength of collateral. The Standardized Approach is part of
the international accord and, as such, would help to achieve
the benefits of harmonization.
In summary, we urge the banking regulators to harmonize the
U.S. version of the accord with the international accord and to
give all U.S. banks, large and small, a choice of capital
compliance options. Moreover, the agencies need to move quickly
to revise general risk-based capital rules that will apply to
banks not adopting the Basel II Advanced Approach.
Furthermore, all options need to be implemented at the same
time. This way, the entire industry can be prepared to follow
standards that are competitively comparable. We also hope the
Committee can support these objectives as the rulemaking
process moves forward.
Thank you very much.
Chairman Shelby. Thank you.
Ms. Marinangel.
STATEMENT OF KATHLEEN E. MARINANGEL, CHAIRMAN, PRESIDENT, AND
CEO, McHENRY SAVINGS BANK
Ms. Marinangel. Chairman Shelby, Ranking member Sarbanes,
and members of the Committee, my name is Kathleen Marinangel. I
appear today on behalf of America's Community Bankers, where I
serve on the board of directors. I am also Chairman, President,
and CEO of McHenry Savings Bank, a community bank in McHenry,
Illinois. We are a $275 million community bank focused on
retail customers and small business owners. We compete head-to-
head with many large national and regional banks.
Let me thank the Committee for its substantial oversight of
the Basel rulemaking process. Your interest has been
instrumental in the progress made to ensure that the banking
industry in general and community banks in particular will be
able to offer competitive services to the communities in which
they do business. We also appreciate the thoughtful
modifications by the agencies to the initial proposals.
ACB, however, remains concerned about competitive and
safety and soundness consequences that might arise from the
rulemaking if it does not remain on track. First, Basel II
should not be implemented until changes are made to Basel I to
address the competitive needs of depository institutions not
suited to the Basel II regime. Otherwise, we believe that Basel
I banks would be left at a serious competitive disadvantage and
would become possible acquisition targets for Basel II banks.
We are pleased that the agencies will soon release a proposal
on Basel IA intended to give these institutions the option to
more closely align capital with risk.
Second, we believe that an optional Basel IA standard must
be designed to permit the majority of banks to more accurately
manage their risks and capital requirements. This should
include more risk buckets and a breakdown of some assets into
multiple buckets to take into consideration collateral values,
loan to value rations, credit scores, and other risk factors.
We would like to stress the importance of addressing every
asset on a bank's balance sheet when finalizing the proposed
formula for Basel IA.
The ANPR addresses some of the assets but not all. Some of
the missing assets that need to be addressed are commercial
real estate loans, bank land and buildings, prepaid assets, and
correspondent bank deposits. Credit guarantees and other
mitigation measures also should be incorporated into the
framework. In short, the system must result in banks of all
sizes having equivalent capital charges against equivalent risk
whenever possible.
Third, we urge that capital standards be implemented in a
manner that will not add significantly to regulatory burdens to
ensure that smaller institutions who do not need complex risk
management systems are not subjected to unnecessary regulatory
burdens. We believe it essential to allow them to maintain the
current Basel I capital regime as an option.
Fourth, flexibility is key to creating a successful new
capital regime. This flexibility should include the option for
Basel II banks to choose between the Standardized Approach and
the Advanced Approach as contemplated in the international
Basel II accord.
Fifth, we strongly support the regulators' intentions to
leave a leverage requirement in place. A regulatory capital
floor must be in place to mitigate the imprecision inherent in
internal ratings-based systems. ACB suggests that the precise
level, however, of the leverage requirement should be open for
discussion.
Finally, as a community banker, I strongly believe that
everyone would benefit if capital requirements better align
capital with risk and if more risk-sensitive options were
available. Advances in technology and the availability of more
sophisticated software would make implementation of a new Basel
IA relatively straightforward for many community banks. For my
bank, there would be little burden and a lot of benefit to my
institution and the community I serve. I need an effective
Basel IA in order to compete.
I thank the Committee for its attention to these important
issues and I will be pleased to answer any questions.
Chairman Shelby. Mr. Isaac, welcome back to the Committee.
STATEMENT OF WILLIAM M. ISAAC, CHAIRMAN,
SECURA GROUP, LLC
Mr. Isaac. Thank you, Mr. Chairman, Senator Sarbanes. It is
really a pleasure for me to be here. I know that you want to
move on quickly, so, I will just try to summarize very briefly.
Plus, I think some of my testimony has already been----
Chairman Shelby. We have been quoting you all morning.
[Laughter.]
Senator Sarbanes. Professor Tarullo ought to give us the
benefit of your thinking here.
Mr. Isaac. Let me try to be quick here.
First of all, I would commend the regulators for doing a
lot of hard work for a long time on Basel II. Everybody is
acting on good faith and trying to get the job done. And I am
not here to criticize anybody. I do not like the result so far,
as you know.
In particular, the advanced modeling approach to Basel II
is just not going to work. I am very concerned with it on a
variety of fronts.
Chairman Shelby. Say that again.
Mr. Isaac. The advanced modeling approach under Basel II--
--
Chairman Shelby. Is not going to work.
Mr. Isaac [continuing]. Is not going to work, in my
opinion. There are a lot of problems with it. It is
fundamentally flawed. If we are going to go forward with it as
an option, I believe that, at a minimum, we must maintain the
leverage ratio where it is. We must maintain prompt corrective
action. And I believe we should maintain the percentage
limitations on reductions in capital that the regulators have
already put into the advanced notice.
If Basel has enough bells and whistles on it, I do not
think it can do a lot of harm. What I really worry about is
that 5 or 6 years from now, or 7 or 8 years from now, when
there are new leaders in the regulatory agencies who are
further removed from the 1980s, they will change those
safeguards. And our system could get into a lot of difficulty.
That is a real concern that I have.
I think that it makes all of the sense in the world to
resolve our Basel II problems. Basel II has been stuck in a
quagmire for the better part of a decade. I believe the
regulations should allow the Standardized Approach.
There is a huge consensus behind the Standardized Approach.
It is less expensive to implement and maintain. It does not
purport to deliver more reliability than can be delivered,
while the Advanced Approach conveys a false sense of security
and reliability. The Standardized Approach is far less
intrusive than the Advanced Approach and will allow the banks
more flexibility to manage themselves and update their models
and not have to seek permission from regulators to change their
own models.
The Standardized Approach is much more transparent and much
easier for all important users of the information to
understand. That would include boards of directors, senior
management, customers, investors, analysts, regulators, and the
media. There are a lot of users of this information, and the
Advanced Approach is not something that is user friendly.
The Standardized Approach will produce a smaller disparity
in capital ratios between large and small banks. Moreover, it
will allow Basel II banks in the U.S. to be treated in the same
fashion as Basel II banks throughout the world because the
Standardized Approach is available throughout the world.
If we were to allow the advanced modeling approach and the
capital ratios of the large banks were to decline, that would
lead to a competitive disparity between the large banks and the
small banks. It would probably lead to faster consolidation of
the industry, and more of it then we would otherwise
experience. And I believe that, in the end, it could be very
harmful to small businesses, because it would deny them more
choices for their banking needs.
I do not buy the argument that foreign banks have an
advantage over the U.S. banks. We have the most profitable
banks and the strongest banks in the world. If we are concerned
about a competitive disparity, I endorse wholeheartedly the
notion that we ought to be trying to get the countries around
the world to impose a leverage ratio on their banks, rather
than allowing the capital ratios of our banks to decline.
Thank you, again, for having this hearing. It is a very
important topic and I am pleased to be a part of the process of
trying to deal with Basel II. Thank you.
Chairman Shelby. Dr. Tarullo, we are glad to have you back
here.
STATEMENT OF DANIEL TARULLO, PROFESSOR OF LAW, GEORGETOWN
UNIVERSITY LAW CENTER
Mr. Tarullo. Thank you, Mr. Chairman, Senator Sarbanes.
In preparing for this testimony as we gather again here
today on this topic, and in listening to the first panel, I
thought what I would try to do is to sum up where I think
things have changed in the last 10 months.
Senator Sarbanes. I think if you drew the mike closer, it
would be helpful.
Mr. Tarullo. Is that OK, Senator?
Senator Sarbanes. Yes, thank you.
Mr. Tarullo. First, as Bill Isaac just intimated, and I
think as your questioning of the first panel suggests, the big
questions about the advanced internal ratings-based approach
that we identified 10 months ago have not been answered in the
intervening time.
We do not know what impact it would have, ultimately, on
capital levels. We do not know what impact it would have on the
ability of supervisors to monitor banks adequately. We do not
know what impact it would have on the ability of our
supervisors to monitor how supervisors in other countries are
implementing it. We do not know what the impact on the
competitive situation of small and medium-sized banks will be.
And we do not know whether the cost of compliance for large
banks is worth it.
I do not know that everyone is prepared to jettison the
advanced internal ratings-based approach conceptually, but I
think most people have moved closer to that position. Most
people, that is, except the regulators, who are trying,
actually, to implement it.
Second, how have the regulators changed in the last 10
months? Well, here I think we have seen some positive movement.
And I, for one, detected a difference in tone this morning from
that which we heard 10 months ago. That reflects, I think, more
experience perhaps. It is definitely reflected in the notice of
proposed rulemaking, where the regulators as a group have
strengthened the safeguards which they will impose-precisely
because of all those unanswered questions. The regulators
themselves identified in the NPR the uncertainty about the
effects of the A-IRB approach of Basel II. They identified the
concerns that they have as a result of the fourth quantitative
impact study.
I think that was the proper response. There are serious
questions about the methodology as a whole, but to the degree
we are going to try to learn about it, we are not going to
learn about it by driving at 60 miles an hour around a hairpin
turn in deep fog without knowing where we are going to come out
on the other side. So we should have some rules, some limits,
and some brakes applied.
Third, where and how have the banks' positions changed?
Well, this is perhaps the most interesting development. I am
not surprised that banks are still concerned that they be able
to have lower regulatory capital levels. That is what they are
usually after. They will set their own capital as they think
they need to in the marketplace but, in terms of regulatory
capital, their interest is almost always in having it lower.
The interesting development, though, is the proposal of the
four large banks to use the Standardized Approach. I think this
reflects a recognition that, with the safeguards that are
necessary in the A-IRB approach, it is not clear that they will
get the big capital reductions that they had counted on based
on the QIS studies. Having seen that, they have quite
rationally said ``Let us look at the other approach that is
much less costly to implement, even though it is going to
produce a much smaller decline in regulatory capital, and let
us go that route.'' And, as Bill pointed out, there are a lot
of ancillary benefits for other banks that may come along with
the adoption of the Standardized Approach.
I would just make one further point. The object of Basel
II, as with Basel I, was to create a common minimum approach to
regulation, not a common maximum, a floor and not a ceiling. I
do not think we want our regulators or our representatives in
the Senate thinking that any time the regulators do anything
different from what the Basel accord indicates that it is
somehow inappropriate, that it somehow failed to harmonize
properly.
We are supposed to be providing a safe and sound banking
system in the United States. We are using the Basel accord as a
tool to assure at least a minimum such system in other
countries, and that is the way that we should think about it.
If there are problems--and I endorse Chairman Bair's to move a
leverage ratio forward internationally--if there are problems
with implementation overseas of Basel II, if it is too lax, our
representatives in the Basel Committee should point that out
and should seek the kind of strengthening that will make the
entire global financial system safer.
Thank you.
Chairman Shelby. Mr. Isaac, I will start with you.
We have received testimony suggesting that, unless U.S.
banks can hold as little capital as foreign banks, U.S. banks
will be placed at a competitive disadvantage versus their
foreign competitor. Could you please discuss the relationship
between the amount of capital a bank holds and its
profitability?
U.S. banks are presently very well capitalized and very
profitable. Does this suggest that strong capital requirements
do not adversely affect the competitiveness of banks?
Mr. Isaac. I believe that strong capital requirements are
actually an asset. I think it is one of the great strengths of
our banking system in this country.
For one thing, it makes pricing in the banking industry
more sane. If you have to earn a certain amount of return on
your capital and if you are required to have more capital, you
are going to price your products accordingly and you are not
going to take undue risks. And I believe that during the 1980s,
when our banks and thrifts did not really have enough capital,
they were willing to take a lot of risks because they did not
have that much at stake.
Today, our banks are much saner about pricing their risks
and what risks they take than they were in the 1970s and the
1980s. So, I think that having capital is a competitive
advantage and it also makes our banks much more attractive
partners for people around the world who need financing.
Chairman Shelby. Mr. Garnett, in your testimony you state
that the changes that banking regulators have made in the Basel
II NPR mean that banks will, quote--I am quoting you--realize
few, if any, of the benefits that were anticipated at the
inauguration of the Basel II exercise, end quote.
Could you explain the types of benefits that banks expected
to attain from Basel II but are now unlikely to realize? And if
these benefits include capital reductions, how large must the
capital reductions be for Basel II to be most effective for
banks?
Mr. Garnett. I think it is----
Chairman Shelby. What did they expect in the beginning?
Mr. Garnett. The objectives of the Basel II accord were
very straightforward and simple and certainly the U.S. banks,
certainly the large banks, supported those objectives. Very
simply, those----
Chairman Shelby. What were those objectives?
Mr. Garnett. Very simply those objectives were consistency
of capital regimes globally, useability, in other words, let's
use as much of the internal systems as we can or develop
capital requirements that, in fact, were useable to better
manage risk internally. And aligning capital with risk was the
primary impetus of why we are probably here today talking about
Basel II. That was the primary objective.
We support all of those objectives to this day.
Chairman Shelby. What are your concerns now?
Mr. Garnett. Let me also make one other point regarding the
issue----
Chairman Shelby. Sure.
Mr. Garnett [continuing]. Of our expectations of lower
capital. I do not think there were any expectations whatsoever
at the outset of Basel II. I think there was a lot of time
spent, 6 or 7 years, with regulators trying to get the
measurements to be useful and consistent and aligned with risk.
There has been a lot of talk about the decline in capital
that was discovered in the QIS-4, and rightly so. We believe
very strongly in a safe and sound banking system. I would
caution interpreting the QIS results to the extent that perhaps
conclusions have been drawn today.
First of all, that QIS study was performed in probably the
most benign period, most favorably period in quite some time.
When you have a risk-based capital process where risk is
aligned with capital, when you are taking on less risk, as you
would be, intuitively, in a very benign period, you would
expect some decline in capital.
To conclude that the declines that we saw and the magnitude
of the dispersions that we say in the QIS-4 would have resulted
if the entirety of the Basel II process had been completed. In
other words, were these models validated? Was there substance
behind the data? Was there adequate stress testing to ensure
that there was capital in place in the event of a weak
downturn? None of these other supervisory and management
practices that are employed, not only with the regulators, but
internally in the banks, were ever employed.
So, we kind of did a quick look. I certainly think that the
bank systems at the time were probably not in the greatest
shape. A lot of work has been done since then, but, more
importantly, we did not let the supervisory process play a role
there.
Chairman Shelby. Do you believe that banks are presently
overcapitalized?
Mr. Garnett. I do not know how to pick the magic number.
Chairman Shelby. Sure.
Mr. Garnett. We have decided that the current regime and
the amount of minimum capital that is formulated from that
regime, which, as I have said, we think is probably pretty
broken. We are using that as a benchmark.
I, unfortunately, cannot give you a better benchmark. I
will tell you that, when it comes to the capital planning
process, regardless of whether or not minimum capital will go
down or go up--and by the way, under the Advanced Approach, I
think if you look at what happens to the Advanced Approach
minimum capital during a period of just moderate economic
weakness, not to mention a severe weakness, in fact, the amount
of capital is higher than what it would have been under Basel
I. And there have been some very interesting studies that we
can certainly share with you to demonstrate that conclusion.
Capital management takes the form of a number of different
factors.
Chairman Shelby. It does.
Mr. Garnett. Certainly, minimum capital is something that
is an extremely important part of that process, but so is
making sure that the amount of capital that banks hold today
can provide the appropriate amount of cushion in the event of a
downturn or in the event that balance sheets or risks could not
be moderated or mitigated is also an important part of that
process.
Chairman Shelby. You know, I have been on this Committee a
long time. I do not know, myself, of any bank that has been
well capitalized and well managed and has ever gotten in
trouble. Mr. Isaac might have a different view because of his
background, but if you are well capitalized and well managed,
you are pretty sound, aren't you?
Mr. Isaac. Generally speaking, that is right.
Chairman Shelby. Mr. Garnett, would you support an
international leverage ratio as a way to address some of your
concerns about the competitive problems raised by retaining the
leverage ratio under Basel II?
Mr. Garnett. Mr. Chairman, the concept of an international
leverage ratio is something that, quite frankly, we heard very,
very recently.
Since I am here today----
Chairman Shelby. Would you explore it and talk to us about
it?
Mr. Garnett. I have not had the opportunity to talk with
the members.
Chairman Shelby. Sure.
Mr. Garnett. It is very clear by statements that have been
made by your Committee, as well as the regulators that were
here about half an hour ago that the leverage ratio is probably
not going anywhere soon, even though it is a difference in
regimes, if you would.
So, if you will give us a little bit of time to learn more
about that concept----
Chairman Shelby. Yes. Let you learn more about it----
Mr. Garnett [continuing]. I am sure that we would be more
than happy----
Chairman Shelby. Absolutely.
Mr. Garnett [continuing]. To respond to your question.
Chairman Shelby. Professor Tarullo, are the floors banking
regulators have put in place on the amount capital can fall
during transition periods and after implementation of Basel II
sufficient to reduce the risk of proceeding with Basel II?
Do you want me to say that again?
Mr. Tarullo. Mr. Chairman, I, as you can tell, have serious
doubts about the whole AIR-B approach.
Chairman Shelby. Sure.
Mr. Tarullo. My preference would be that over time we not
implement the A-IRB approach at all.
Having said that, it is part of Basel II. I agree with Mr.
Garnett on the need for choice for the banks that are
confronted with this new regime. Therefore, I think the
regulators have done a reasonable job of putting in place--
retaining, really--one safeguard, which is reflected in
congressional legislation, the leverage ratio. And second, they
have put in place two other kinds of safeguards, one bank
specific, and the other applying to all AIR-B banks.
Might I have calibrated it a bit differently? Perhaps. But
the regulators have a tough job and I think those proposals are
reasonable.
Chairman Shelby. Ms. Marinangel.
Ms. Marinangel. Marinangel.
Yes.
Chairman Shelby. In your testimony, you support maintaining
the leverage ratio as part of Basel II as a way to mitigate the
imprecision inherent in a ratings-based capital requirement
system. Would you explain why a ratings-based system is, quote,
imprecise, and would you explain how maintaining the leverage
ratio will help level the playing fields for community banks
when they compete against banks that have Basel II, if that
happens?
Ms. Marinangel. Any system, any internal ratings-based
system is, of course, only as precise as the data that you put
into the system. And, as you know, any software program that
you design for risk management includes subjective input.
Therefore, there would be imprecision.
The leverage ratio, I think, is important to maintain. I do
not know if the current level is the right level but I think it
does add stability. I would like to comment a little bit, as
well, about the reduction in the required level of capital held
when you risk weight assets. From a community bank's point of
view, and from my point of view, even before Basel II was being
introduced, I guess I was very frustrated about the fact that
the capital held for the assets did not truly reflect the risk.
So, for many years I was working on trying to modify Basel
I through the regulatory agencies and through the national
trade groups. I actually have run the Basel IA model myself in
my shop and there also is a reduction in the required capital
level. And that is because some of the assets are, you know, a
90 percent loan-to-value mortgage is weighted the same as a 20
percent loan-to-value mortgage and that does not make any
sense.
So, I am not too concerned about the drop in the level of
capital required when you risk weight the assets. I guess from
my point of view, in my small community and doing the small
business loans, it would be helpful to have a reduction in the
capital held for risk-based assets. It would allow me to make
more small business loans, and, for example, a small business
loan to a person who has a lot of collateral backing it, let's
say a guarantor that has a high net worth, would allow me to
risk weight that loan lower in a lower bucket and hold less
capital. Let's say that you might even weight that commercial
small business loan at 50 percent. It would allow me then to
make more business loans in my community. And it is critical.
So, I really am not as concerned--and we have talked a lot
about Basel II, but it so important to talk about Basel IA for
the 9,000 community banks that will work this. And it can be
Basel IA, it could be the Standardized Approach, but if I
cannot risk weight those assets properly, then I am held back
from making more loans.
Also in my town, just for your information, I have 28 banks
in my town of 24,000. I have many national banks, Citibank,
J.P. Chase Morgan. I also have foreign banks in my town,
Harris, LaSalle, Bank of Scotland. So, I have to be able to
compete. I can make more loans if I can risk weight my assets.
Chairman Shelby. But if you can compete on a level playing
field, you can----
Ms. Marinangel. Absolutely. I need to. Yes. I need to be
able to.
So, I am not as upset or concerned about the lowering of
the capital when you risk weight even Basel II Advanced A-IRB
Approach or in a Basel IA that allows me to risk weight. You
will have a drop because these assets are not being reflected
properly. So, I am not as concerned about it as everybody else,
as long as all of us can truly reflect the assets so I can
serve my community.
Chairman Shelby. Are a lot of your customers small
businesses, startup companies, and everything?
Ms. Marinangel. Well, we have some startup, but we also
have some pretty established customers. We do a lot of consumer
lending. We do indirect financing for auto and RV and boat
dealers. So, my goal had been to diversify assets so that I can
reprice----
Chairman Shelby. Sure.
Ms. Marinangel [continuing]. After the savings and loan--
and I had been a State-chartered savings and loan, but now I am
a savings bank charter.
You know, we had to be able to diversify assets for
repriceability. So, a lot of the commercial mortgages and real
estate loans adjust with prime, and consumer loans, a third
reprice annually. So, yes, we are very diversified and we feel
we can compete as long as we have a level playing field.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman.
I want to address these models that are being posited under
Basel II. First of all, I understand the Basel II require that
banks have a minimum of 5 years of data; is that correct?
Mr. Garnett. I am sorry, were you addressing that to me,
Sir? Yes, that is----
Senator Sarbanes. Yes, well, I think I should go to the
bankers first.
Mr. Garnett. Yes, Sir. That is correct.
Senator Sarbanes. OK.
Now, I am concerned about how confident we can be that
banks have enough historical data in their internal risk-based
models to provide accurate evaluation of risks. How many years
of data do most banks have for building their models?
I guess I should go to you again, Mr. Garnett, because you,
essentially, I guess, speaking for the banks that were engaged
in the process of building the models.
Mr. Garnett. Yes, Sir. I do not think that there is a
single number I could give you. I could probably give you a
range. There are banks that have as many as 30 years worth of
data, other banks that may not have that much.
Senator Sarbanes. Are you giving away a propriety secret if
I ask you how many years of data does Citi have in its model?
Mr. Garnett. I would prefer not to have to answer that
question, if you do not mind, Sir.
Senator Sarbanes. I am told that the banks were told to put
recession into their data, since we do not really have a
recession over the last 15 years. So, if your bank's data does
not run for a period longer than 15 years, it is not factoring
in a recession; is that right?
Mr. Garnett. That could very well be the case. I am not
familiar with the term, building a recession into the data.
What I am familiar with, and it is a very important part of
Basel II, is Pillar 2 requirements with regard to stress
testing. It is clearly very important to make sure that the
capital levels that are required in both good and bad times is
achievable. And by looking at stress tests, it is a very
important way of making sure that there is a capital planning
process if we happen to be doing this exercise in a good time,
to make sure that there is a flexibility and a capacity for
that organization individually to meet minimum capital
requirements in the even of a downturn.
Now, that could take the shape of various activities on the
balance sheet. It is not just a capital, necessarily, action
plan. But stress testing is an extremely important part of
Basel II. And it gets at the point that--I agree 100 percent
with you. You cannot simply assume that if we are operating
with data that has been, you know, in very good times, that
that will necessarily be the best predictor of what happens
tomorrow. That is why Pillar 2 and Basel II are extremely
important.
Senator Sarbanes. Well, let me ask you and Ms. Marinangel.
Were you taken aback by the results of the fourth QIS, which
showed these very substantial reductions in capital for some of
the major banks? Did you expect that the models would produce
that kind of result?
Mr. Garnett. Well, because----
Senator Sarbanes. Let me preface that by underscoring the
concern here because the regulators, from the very outset, in
presenting their efforts on Basel II, and we have been
following it for quite a while, but at the very outset said
that this was not going to lead to any significant reduction of
capital in the banking system. We were repeatedly told that.
Ms. Marinangel. If I could answer first on this.
I was not taken aback by that because I believe that, as I
said before, assets are not risk weighted properly. I am also
not as concerned. I feel that.
Senator Sarbanes. Well, let me just interrupt you right
there on the weighting of the assets and evaluating the risk.
As I understand it, the regulators now are considering
issuing guidance to the banks with respect to commercial real
estate. They are concerned about the developments in commercial
real estate and therefore may provide some guidance and caution
and so forth.
Yet, under the Basel II advanced proposal, the commercial
real estate basket, or however you want to call it, had a 30
percent drop in capital. Now, how do you square that? Here we
are, if we had gone with Basel II this particular category had
a 30 percent drop, and yet the regulators right now are about
to issue, as I understand it, guidance to the banking industry.
Ms. Marinangel. I think I, as Mr. Garnett said,
historically, we have had a very healthy industry.
Senator Sarbanes. All right. Let us do that. You have a
healthy industry. You come along and you do Basel II and the
market deteriorates. Now, presumably the deterioration in the
industry will occur more quickly than the adjustment in the
Basel II standards. What do you do in that situation?
I mean, things are going bad, you have less capital because
you did these evaluations, and then, all of a sudden, you are
out there on the end of the plank. What do you do about that
situation?
Mr. Garnett. Again, I think the pillar 2 comments that I
made just a minute ago address that concern. And that concern,
Senator, is a very, very valid concern and should not be
overlooked in any way.
If you are using models that are picking up 5 years, 10
years, whatever many, 8 years, you are using, and you go into
an economic downturn, it will take a while for those models to
catch up and recognize the severity of the current situation.
That is a known, I would not call it a weakness, but just an
inherent part of the model. That is why the Pillar 2
supervisory oversight is so important.
And as banks are now implementing internationally the
Pillar 2 oversight process, the stress testing, the rigorous
validation and back testing that have to go along before you
are even approved to use the Advanced Approach is a definite
part of the accord that needs to be there. And again, I think
that we need to be careful that we are not making assumptions
too quickly about just Pillar 1 results when it comes to the
total picture.
Senator Sarbanes. Mr. Isaac, Mr. Tarullo, why don't we hear
from the two of you on this point?
Mr. Isaac. Which point, how far back the models go----
Senator Sarbanes. Well, that, and also, if the model gives
you a lower capital requirement and then the situation goes
badly, it seems to me you are caught in a very difficult
situation. How do you rectify that situation? If you put the
pressure on the institution and raise its capital standards
because things are going bad, of course they are, conceivably,
are in a difficult situation as it is. So, they are confronted
with an even more difficult problem.
Mr. Isaac. I have talked to a lot of Basel II banks--not
all of them but a lot of them--and I do not know any bank that
has data that goes back more than 10 years and most of them do
not go back 10 years.
For one thing, the banks do not even look today like they
looked 10 years ago because there have been so many mergers and
so many systems that have been crammed together. So, I do not
believe the data will go back as much as 10 years in most of
these banks.
Senator Sarbanes. Do you differ with that, Mr. Garnett?
Mr. Garnett. I think there are probably exceptions to what
Mr. Isaac suggests.
Mr. Isaac. And I allow that there may be exceptions.
Senator Sarbanes. But that is the rule, I take it. What he
said is basically the rule.
Mr. Garnett. Unfortunately, I know more about my own
institution, and we agreed that we would not share that data
publicly here, but I do what every other banking institution
does. So, I apologize for not being more precise.
Senator Sarbanes. All right.
Mr. Isaac. I think the four banks have just made a huge
contribution to the Basel II process by suggesting the
Standardized Approach be made available in the U.S. because it
is the way out of the quagmire we are in. My basic problem with
the Advanced Approach is that I do not believe any models
should be relied on so extensively. You should not place all of
your faith in them. We have got to have absolute floors below
which nobody can go.
There was a lot of talk until about a year ago that Basel
II was going to supplant the leverage ratio. I heard speeches
made by regulators saying that.
Senator Sarbanes. Oh, yes.
Mr. Isaac. That would have been a terrible mistake, in my
judgment. Look, for example, at long-term capital management.
It was run by world famous economists and mathematicians who
believed they had the perfect models. I am sure we could all
come up with example after example where models just cannot
predict everything.
So, my main concern is that we not place too much faith in
models. They are not foolproof. We have to make sure that they
are not so complex that nobody can understand them. I want
boards of directors of banks, managements of banks, analysts,
investors, the Congress, and the regulators to be able to
understand how the models are working. I think pretty much
everyone can get a handle on the Standardized Approach.
Whatever we use, we have got to put floors under it. If the
rest of the world wants to have lower floors, or no floors,
then so be it. We need to be focused on making sure that our
banks are the best banks in the world. They are right now, and
I do not want to see us do anything to change that dynamic.
Senator Sarbanes. Professor Tarullo.
Mr. Tarullo. Senator, I think your last question raises the
issue of what a minimum capital rule is supposed to do. And
what I think a capital rule should do is, first, to provide, as
Bill just said, a floor, a genuine floor. But second, it has
got to be a floor that has meaning, that is stable, and that
gives a signal fairly quickly.
If you have got lags before the model takes things into
account, the model is not going to be providing the supervisor
with the warning signal that some intervention needs to be made
in the bank. So I think that the virtue of the leverage ratio
in the United States under the prompt corrective action system
that the Congress instituted about 15 years ago has been--
notwithstanding its simplicity and, frankly, its bluntness--
that it does serve as a clear and very difficult to manipulate
floor, which, when a bank drops below it, sets off alarm bells
here in Washington and tells supervisors that intervention is
necessary.
The other point that I think we should reiterate--I think
it has been lost a bit--I certainly do not have the view that
the leverage ratio is the only tool for supervision that a
regulator should use. To the contrary, I think that Mr. Dugan's
stated aim last year and this year of making sure that he can
get his arms around the risks that a bank is actually assuming
is a very important aim. And models, internal credit risk
models, are an important tool that the banks use to figure out
what is going on in their institution and that regulators can
use to figure out what is going on in that institution. That is
not the same thing as saying that they should be used to set
minimum capital standards.
Mr. Isaac. I want to particularly endorse the last
statement. I agree with everything Professor Tarullo said, but
that last statement is very important. The models have a good
use; it is just not for setting minimum capital standards.
Mr. Tarullo. And Senator, one other thing--I really do not
want our banks to have to spend a lot of money on a duplicative
process that they do not find particularly useful for internal
risk purposes and that is not a particularly good standard for
the regulators to use, either. That is why I think Bill and I
both--to some degree--endorse the banks' approach with the
standardized option.
Senator Sarbanes. I might note that I spared Ms. Bies'
today her quote, in which she said that the purpose of this
exercise--that eventually they would get rid of the minimum
capital leverage ratio. But you know I am greatly influenced by
evaluating proposals by, sort of where you say, well, I know
where you are coming from. That has been one of the
difficulties here, particularly with the Feds----
Mr. Garnett, I just wanted to put a couple--I am just
curious. What prompted you and the other three banks to take
this public position?
I gather in the end, you ended up meeting, going to OMB--
you were the only one who went, as I understand it. Of course
that ran the risk of bringing down on you the ire of the
regulator. So, it was not, sort of a, it seems to me, sort of a
run of the mill decision. So, what was it that prompted you to
do that?
Mr. Garnett. I think it was said very clearly this morning.
If we are setting the rules for how risk will be priced
globally through the Basel II or other versions of it, whether
it is Basel I or Basel IA, I think it is extremely important to
get it right.
We need to get it right for safety and soundness reasons.
We need to get it right for competitive reasons. We are not
dismissive of the differences that exist in the NPR versus the
international text. We are very supportive of floors during a
transition period. We would just like the floors to be
consistent with those floors that are put there for safeguards
by the international community.
The importance of getting it right led us to believe that
we needed to make sure that the OMB was--we shared our thoughts
with that agency as we are permitted to do and probably are
expected to do.
With regard to introducing the Standardized Approach, there
were two reasons for that. First of all, we realized that we
had a domestic issue on our hands. If we were going to permit
12 to 20 banks to use a risk-sensitive, capital aligned with
risk approach and have the rest of the community banks, or
small banks, or even fairly large banks on a Basel I non-risk-
sensitive approach.
Senator Sarbanes. Well, it would be everybody else----
Mr. Garnett. Everybody else----
Senator Sarbanes [continuing]. Except the 12 to 20 banks,
right?
Mr. Garnett. Correct.
We realized, and perhaps--we being, probably, predominantly
the largest banks, we realized a little bit late that that
competitive domestic disadvantage was being created.
So, one of the reasons that we introduced options, and they
could go well beyond Standardized, and Basel IA is another
example of an option that could be a very viable approach for
banks in this country. We have yet to see what it really looks
like.
So, that was reason No. 1. Reason No. 2 was that we saw in
the NPR revisions that, in our view, were going to cost the
industry an enormous amount of money, millions of dollars, to
have to adjust to, particularly the internationally active
banks, where we are, as we speak, implementing Basel II
practically everywhere but here.
So, if we are forced, based on revisions from the
international accord, to spend more money on data, different
calculations, on systems--that did not seem to be a good use of
our money.
Senator Sarbanes. Are you implementing it internationally
according to the Standardized Approach which is available, as I
understand it?
Mr. Garnett. I am going to make it less personal. There are
banks, U.S. banks, international U.S. banks, implementing
Standardized and Advanced via the international accord
overseas.
Senator Sarbanes. OK, thank you Mr. Chairman.
Chairman Shelby. Thank you.
Professor Tarullo and former Chairman Isaac, Chairman
Bernanke stated to this Committee this past summer that he had
reservations about the appropriateness of the Standardized
Approach to large global banks because it did not, in his
opinion, adequately address the types of risk they assume. Do
you agree with this view? And, if so, why should large banks be
allowed to adopt a capital requirements regime that does not
fit their business?
Mr. Isaac. I am not sure what Chairman Bernanke had in mind
and so I cannot really address his remarks. I believe that
models are a very important management tool in identifying,
pricing, and managing risk in a large, complex institution.
I believe that the regulators, to the extent that large
banks are not focused on modeling their risks, and I think they
all are, but to the extent that they are not, the regulators
ought to be pushing them.
But we are not talking about that here. We are talking
about what tool should the regulators use to regulate capital,
to put floors on capital in the system. I believe that the
Standardized Approach is vastly superior to the advanced
modeling approach. All we are doing when we go to the advanced
modeling approach is forcing the large banks to run two
systems. They are going to have to run their own system and
they are going to run the regulatory system, or they are going
to run one system that they cannot change unless and until the
regulators say they can. And so I think we are just heaping
expense on top of expense and I believe the Standardized
Approach is superior by a long shot.
Chairman Shelby. Professor.
Mr. Tarullo. Mr. Chairman, on the first point, is the
Standardized Approach sufficient to regulate large, complex
banking institutions? Absolutely not, for the reasons that we
have stated previously.
But you always have to look at what your viable
alternatives are. And with all the questions about the advanced
internal ratings-based approach, some of which I detailed
earlier, I think it is an enormous heroic leap of faith by
anyone to say that it currently constitutes a viable
alternative. Policy-making is always a choice among your viable
alternatives, not among some idealized view that you hope you
can realize.
Chairman Shelby. We better know where this road leads, had
we now, Mr. Isaac?
Mr. Isaac. I agree.
Chairman Shelby. And I do not think we know today where
this road will take us to in the financial service industry.
Thank you for your testimony. Thank you for your
participation in this issue. You can tell that we still have a
lot of concerns on this issue. The Committee is adjourned.
[Whereupon, at 12:47 p.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM JOHN C.
DUGAN
Q.1.a. Your agency had previously decided that Basel II banks
would be allowed to use only the Advanced Approach. Why did
your agency originally decide not to allow banks to use the
Standardized approach?
A.1.a. In the United States, the Agencies chose not to subject
all US. banks to Basel II, but instead to focus on only the
largest and most internationally active banks. There were four
primary reasons for not subjecting all U.S. banks to mandatory
application of Basel II, which by definition was designed for
applicability to internationally active banks. First, a very
large number of U.S. banks, particularly smaller institutions,
maintain capital well above any regulatory minimums or PCA
requirements, and changes to risk-based capital rules for these
institutions impose a regulatory burden in exchange for very
little, if any, supervisory benefit. We have heard this message
repeatedly from the industry in response to earlier regulatory
capital proposals. Second, in our assessment, Basel II's
Standardized Approach for credit risk offers only marginal
improvements in risk sensitivity. Perhaps the most significant
improvement in the Standardized Approach is the introduction of
rules to capture the risks of securitizations, which is notably
absent from the 1988 Accord, but which the United States has
had in place for many years. Consequently, the relative
improvement in the Standardized Approach versus current rules
is much less in the United States than in many Basel Committee
member countries. Third, the Standardized Approach to credit
risk was calibrated on the premise of an accompanying charge
for operational risk. The OCC remains strongly opposed to a
specific charge for operational risk for most U.S. banks, which
have neither the ability nor the need to measure operational
risk under the Advanced Measurement Approaches. Finally,
because some of the changes in Basel II, such as charges for
securitizations or operational risk, result in capital charges
where none previously existed in some countries, the Basel
Committee was under great pressure to make compromises to ease
the burden on countries adopting new charges for the first
time. That resulted in risk weights for some specific exposure
types, such as, for example, retail and small business
exposures, that we believe are inappropriately low.
In contrast to the simpler approaches of Basel II, the
Agencies believed that the advanced methodologies--that is, the
Advanced Internal Ratings Based (AIRB) and Advanced Measurement
Approach (AMA)--were the most appropriate approaches for
calculating credit and operational risk capital requirements
for the largest and most complex internationally active U.S.
banks.
We proposed that the largest banks be required to use the
Advanced Approaches for the following reasons: (1) the Advanced
Approaches are the most consistent with--although certainly not
identical to--large bank practices in the areas of risk
management and risk measurement, and (2) the risks that large
banks take warrant the application of more advanced risk
measurement and management techniques to better ensure the
safety and soundness of these institutions.
Q.1.b. Why have you now decided to re-evaluate this decision?
A.1.b. Prior to the official U.S. publication of the Basel II
notice of proposed rulemaking (NPR) the Agencies received
comments from numerous interested parties requesting additional
options for Basel II implementation. These requests most often
cited competitive equity issues, especially in an international
context. We have been and remain concerned about competitive
equity issues raised by the implementation of Basel II, and
because these unsolicited comments clearly generated a great
deal of interest in the industry, we felt it appropriate to
specifically solicit a wider range of comment on this
particular issue.
Q.1.c. What factors will you consider when deciding whether to
allow banks to use the Standardized Approach? Given that Fed
Chairman Ben Bernanke during his last appearance before the
Banking Committee expressed concerns about whether the
Standardized Approach is appropriate for large, global banks,
is the Standardized Approach a realistic alternative for our
biggest banks?
A.1.c. Like Chairman Bernanke, we question whether the
Standardized Approach would be appropriate for the largest and
most sophisticated banks. Nonetheless, as noted above, we are
open to comments on that question. Ultimately, a decision
whether or not to provide the largest and most sophisticated
U.S. banks with the option of the Standardized Approach will
depend on further analysis of the extent to which U.S. banks'
competitors are likely to use that approach, and more
importantly, whether it can in fact provide an appropriate
measure of capital adequacy at the most sophisticated banks we
supervise.
Q.2. The Basel II NPR has been criticized by several banks
because it deviates from the international Basel II accord by
imposing floors on the amount capital can fall. As a result,
some banks maintain that the Basel II NPR would not be cost
effective for them to adopt.
A.2. The Basel Committee's June 2004 publication (the ``New
Accord'' or ``Basel II'') includes transitional floors on the
amount that an individual bank's minimum required capital can
fall in each of the first two years of implementation. The U.S.
NPR also incorporated temporary floors on the amount capital
may fall, with a three-year transitional period. In addition to
lengthening the transitional period by one year, the Agencies
modified the floor calculation in a way that made the floor a
more effective measure than the calculation contained in the
New Accord. We did so because of the safety and soundness
concerns that arose as the result of our fourth quantitative
impact study (QIS-4), where we saw significant dispersion and
drops in capital requirements. Authorities in several other
countries do not anticipate similar reductions in required
capital under Basel II. Because the underlying calculations of
the Basel II capital requirements are generally not affected by
these broad, bank-level and system-wide floors, it is not clear
how the removal of the U.S.-specific floors would make the U.S.
implementation more cost effective (apart from the fact that
the level of required capital would be decreased). We believe
that the underlying calculations of the U.S. NPR are entirely
consistent with both the international implementation of Basel
II and with bank risk management practices, and that the U.S.
deviations from the Basel II Framework reflect a prudent
approach to implementation in the United States.
Q.2.a. Do you believe that these concerns about the costs of
Basel II as set forth in the NPR are justified?
A.2.a. We believe these concerns may be overstated. They focus
only on the perceived private ``benefit'' of a reduction in
required capital for individual Basel II banks, and ignore
other legitimate public policy considerations. It may be
natural that banks would prefer not to incur costs that do not
result in a direct benefit to the bank or its shareholders. It
is also fair to say that some banks believe a more risk-
sensitive regulatory capital regime should lower their capital
requirements--in some cases, lower than we will allow under
Basel II. While we recognize the significant expenditures
required of banks (and tried to limit these costs by designing
Basel II requirements to reflect existing risk management
systems and processes to the extent possible) these costs must
be weighed against the benefits of greater safety and soundness
of the banking system, which, by their nature, are much more
difficult to quantify. Ultimately, decisions about capital
regulations cannot be based on bank-by-bank evaluations of
costs and benefits or ``cost effectiveness,'' since much of the
benefit may not accrue to individual banks. However, as with
all aspects of this proposal, we are interested in hearing the
views of all interested parties on the cost-benefit tradeoffs.
Q.2.b. Could you please give us a comparison of the estimated
costs to implement Basel II versus the expected benefits of
Basel II for a typical bank?
A.2.b. The OCC considered the costs and benefits to implement
Basel II as part of our regulatory impact analysis. Our
analysis of the proposed rule identified the following
potential benefits, some of which accrue to individual banks,
others to the banking system or to the public more generally.
1. Better allocation of capital and reduced impact of
moral hazard through a reduction in the scope for regulatory
arbitrage.
2. Improves the capital measure as an indicator of
capital adequacy.
3. Encourages banking organizations to improve credit
risk management.
4. More efficient use of required bank capital.
5. Incorporates and encourages advances in risk
measurement and risk management.
6. Recognizes new developments and accommodates
continuing innovation in financial products by focusing on
risk.
7. Better aligns capital and operational risk and
encourages banking organizations to mitigate operational risk.
8. Provides for enhanced supervisory feedback.
9. Enhanced disclosure promotes market discipline.
10. Preserves the benefits of international consistency
and coordination achieved with the 1988 Basel Accord.
11. The ability to opt in offers long-term flexibility to
nonmandatory banking organizations.
As for costs, because banking organizations are constantly
developing programs and systems to improve how they measure and
manage risk, it is often difficult to distinguish between
expenditures explicitly caused by adoption of the proposed rule
and costs that would have occurred irrespective of any new
regulation. Nevertheless, we included several questions related
to compliance costs in QIS-4. Based on figures supplied by 19
QIS-4 respondents (out of 26 total QIS-4 participating banks)
that provided estimates of their implementation costs, we
estimate that organizations will spend roughly $42 million on
average to adopt the proposed rule. We expect to receive
additional information on implementation costs in the NPR
comment process.
Q.2.c. What impact will the deviations from the international
Basel II accord have on the global competitiveness of U.S.
banks?
A.2.c. Our intent is to have a regulatory capital framework
that enhances the safety and soundness of the U.S. banking
system without compromising its competitiveness, either
internationally or domestically. Data show that large U.S.
banks have more capital and are more profitable than their
European Union counterparts, so it is clear that strong capital
positions can be fully consistent with strong performance and
profitability. We do not believe that there is a trade-off
between safety and soundness and competitiveness. In
particular, we have not yet seen evidence that the absence of
the option of the Standardized Approach for U.S. mandatory
Basel II banks will impair their ability to compete with their
foreign counterparts. Large U.S. banks and almost all large
foreign banks would be using the Advanced Approaches. Our
understanding is that the largest foreign banks plan on using
the Advanced Approaches, even though many of them technically
have the option of using the less sophisticated Standardized
Approach. While there are certainly differences in how these
Advanced Approaches are being implemented in the United States,
many of these differences are temporary. For example, the
biggest difference is that the U.S. proposal has a limit on the
amount that capital requirements may drop during the first
three years of implementation. We felt this was needed to
ensure that safety and soundness is not compromised. There are
other technical differences as well, and we will use the
comment process to further evaluate these.
While harmonization of regulatory capital rules will
advance the goal of a level playing field, there are limits to
how much consistency we can achieve on an international basis
due to differences in accounting regimes and significant
differences in the process of bank supervision. However, even
with existing differences, including difference in capital
requirements, U.S. banks are extremely competitive
internationally.
Q.3. Are banks presently over-capitalized? Please explain how
you arrive at your conclusion.
A.3. We do not believe that the U.S. banking system is
overcapitalized. Various independent indicators of bank
soundness--such as bank failure rates, external ratings of debt
issued by banking institutions, and credit spreads on bank
debt--are reasonably aligned with historical norms for the
U.S.; they are neither especially high nor especially low.
These indicators suggest that, at least in very broad terms,
both market forces and regulatory requirements are achieving
appropriate levels of bank capital. However, we believe that
the current regulatory capital regimes need improvements to
better reflect risks that banks are taking. Basel II does that
for the most sophisticated U.S. banks, and through the Basel IA
NPR we are exploring improvements in the risk-based capital
rules that might apply to other banks.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM JOHN C.
DUGAN
Q.1. What is the ratio of tangible equity to assets at the 15
largest bank holding companies? Would it be appropriate to
allow this ratio to drop substantially? What floor if any would
you place under this ratio? Should it go below 5%?
A.1.
TABLE 1. CAPITAL RATIOS FOR LARGE U.S.-OWNED BANK HOLDING COMPANIES JUNE 30, 2006
----------------------------------------------------------------------------------------------------------------
Tier I Leverage Ratio Tangible Equity Ratio
BHC Name (%)* (%)**
----------------------------------------------------------------------------------------------------------------
Citigroup................................................... 5.19 4.56
Bank of America Corp........................................ 6.13 3.73
JPMorgan Chase.............................................. 5.85 4.60
Wachovia.................................................... 6.57 4.59
Wells Fargo................................................. 6.99 6.29
U.S. Bancorp................................................ 8.23 5.52
Countrywide Financial....................................... 6.96 7.04
Suntrust Banks.............................................. 6.82 5.88
National City............................................... 6.89 6.66
BB&T........................................................ 7.26 5.50
Bank of New York............................................ 6.22 4.99
Fifth Third................................................. 8.38 6.94
State Street................................................ 5.46 4.39
PNC Financial............................................... 7.71 5.24
Keycorp..................................................... 8.82 6.71
----------------------------------------------------------------------------------------------------------------
* Tier 1 Leverage ratio equals regulatory tier 1 capital divided by average total assets.
** Tangible Equity ratio equals GAAP equity, less intangibles (except mortgage servicing assets that have an
identifiable stream of income) divided by average total assets.
The OCC has no intention of allowing bank capital
requirements to drop precipitously. Our experiences in the late
1980s and early 1990s, and the role that capital played in the
subsequent resurgence of the industry's survivors, reinforce
our belief in strong capital. Moreover, the leverage ratio is a
crucial element of our current regulatory capital and prompt
corrective action frameworks, and has coexisted with the risk-
based regime for many years now. We are not proposing any
changes to the leverage ratio requirements.
Q.2. We have been led to believe that the goodwill and other
intangibles represent roughly one-third of the U.S. industry's
equity. Is that correct?
A.2. In June 2006, there were 7,559 insured commercial banks.
In the aggregate, the ratio of these banks' intangible assets
to equity was 30.5 percent. Note that, in forming a bank's tier
1 ratio for regulatory capital purposes under 12 CFR Part 3,
the largest portion of these intangibles (i.e., goodwill and
core deposit intangibles) are deducted from the measured amount
of tier 1 capital. Thus, the Agencies, in effect, assign a
dollar-for-dollar requirement on these intangibles. Because the
regulatory measure of the tier 1 capital ratio deducts these
intangibles first, before dividing by assets, we are confident
that the measured ratios reflect a sound regulatory standard.
Q.3. At this point, only the U.S. and Canada have minimum
leverage ratio requirements. Should U.S. bank regulatory
agencies be comfortable with an international system for bank
capital that does not impose such requirements in other
countries? With the subjectivity involved with the Advanced
Approach of Basel II, does this lack of a leverage ratio
requirement concern you from the perspective of international
financial stability?
A.3. The issue of an international leverage ratio is currently
being discussed internationally. From these discussions it
appears that other countries use tools other than a leverage
ratio to provide a capital cushion. The Basel Committee's
Accord Implementation Group has surveyed the countries that
participate on the Basel Committee to determine what other
mechanisms are being used to ensure capital adequacy above the
regulatory minimums.
Q.4. The Standardized Approach would (1) be less costly than
the Advanced Approach for both banks and agencies, (2) be less
likely to substantially reduce capital requirements, and (3)
have a lower chance of opening competitive disparities between
U.S. banks of different sizes. Under these circumstances, why
should the agencies not allow such an approach for any U.S.
bank?
A.4. The Standardized Approach and the Advanced Internal
Ratings-Based Approach (AIRB) share a primary goal--improved
risk sensitivity in the risk-based capital regime. The crucial
distinguishing factor between the two efforts turns on (1) the
need for improved measurement and management of complex risks
in the largest banks, and (2) the need to avoid both complexity
and expense in the Standardized Approach to the maximum extent
possible. AIRB is designed for the systems that very large,
complex organizations should be capable of building and can
afford to develop and operate.
In our assessment, Basel II's Standardized Approach for
credit risk offers only marginal improvements in risk
sensitivity for the United States. Perhaps the most significant
improvement in the Standardized Approach is the introduction of
rules to capture the risks of securitizations, which is notably
absent from the 1988 Accord, but which the United States has
had in place for many years. Consequently, the relative
improvement in the Standardized Approach versus current rules
is much less in the United States than in many Basel Committee
member countries. Moreover, the Standardized Approach to credit
risk was calibrated on the premise of an accompanying charge
for operational risk. The OCC remains strongly opposed to a
specific charge for operational risk for most U.S. banks, which
have neither the ability nor the need to measure operational
risk under the Advanced Measurement Approaches. Finally,
because some of the changes in Basel II, such as charges for
securitizations or operational risk, result in capital charges
where none previously existed in some countries, the Basel
Committee was under great pressure to make compromises to ease
the burden of countries adopting new charges for the first
time. That resulted in risk weights for some specific exposure
types, such as, for example, certain retail and small business
exposures, that we believe are inappropriately low.
In the Basel II NPR we asked for comment on whether the
largest U.S. banks should be given the option of choosing the
Standardized Approach and are open to evaluating the responses.
Ultimately, a decision whether or not to provide the largest
and most sophisticated U.S. banks with the option of the
Standardized Approach will depend on further analysis of the
extent to which U.S. banks' competitors are likely to use that
approach, and more importantly, whether it can in fact provide
an appropriate measure of capital adequacy at the most
sophisticated banks we supervise.
Q.5.a. The Advanced Approach of Basel II has been touted as
addressing safety and soundness concerns related to hidden and
undercapitalized risks that large, complex banks now take under
the current rules. In the results of QIS-4, what was the
aggregate change in minimum risk-based capital requirements for
securitized exposures?
A.5.a. The minimum required capital (MRC) for securitization
exposures decreased 17.9% from Basel I to Basel II. Note that
this change includes all securitization exposures, rather than
solely off-balance sheet exposures. As we have noted in other
contexts, we have proposed measures in the U.S. Basel II NPR to
limit potential declines in regulatory capital during an
extended transition period. We also note that for a number of
reasons, highlighted in our interagency release of QIS-4
results, the results of QIS-4 should not be considered
definitive indicators of expected results upon full
implementation of Basel II. Finally, it should be recognized
that unlike the United States, many countries currently have no
specific framework for securitizations.
Q.5.b. For other off-balance sheet exposures?
A.5.b. The aggregate MRC for other off-balance sheet exposures
decreased by 10%.
Q.5.c. If the current rules are insufficient to address these
complex risks, is it because they require too much capital, or
too little capital?
A.5.c. We believe the current regulatory capital regime needs
improvements to better reflect risks that banks are taking. For
example, the current Accord assigns a 100 percent risk weight
to the large majority of private sector borrowers. This single
risk weight assignment is not at all reflective of the true
differences in credit risk (i.e., the risk of default) across
borrowers. Thus, from a supervisory perspective, the issue is
not driven by a portfolio-by-portfolio assessment of whether
the current rules require too much or too little capital; the
strength of the Advanced Approach is its improved accuracy in
the areas of risk management and risk measurement. The
improvements in risk measurement--riskier assets will be
assigned a higher risk weight, which is more reflective of the
risk they pose to the bank--will result in a more risk
sensitive bank specific capital requirement.
Q.6. If the goal is to encourage sophisticated risk measurement
and management at our largest banks, why can't they be
encouraged adequately through pillar 2's supervisory guidance
and pillar 3's transparency through public disclosure?
A.6. The Agencies considered requiring large banks to implement
advanced risk management systems without tying those
requirements to minimum regulatory capital. However, this
approach was rejected because of the need to have a more risk
sensitive regulatory capital framework that: (a) reflects the
sophistication and complexity of modern day risk measurement
systems and practices; (b) more closely aligns regulatory
capital with actual risk taking; and (c) provides appropriate
recognition to credit risk mitigation techniques in order to
provide an incentive for risk mitigation behavior and pro-
active risk management on the part of banks. In addition, Basel
II is expected to greatly facilitate the use of a common set of
credit-risk measurement metrics that will enhance the ability
of the OCC and other regulators to conduct benchmarking and
early warning analysis across the population of large complex
banks.
Q.7. If the mandatory banks operate under the Advanced Approach
and other banks operate under Basel IA, how much do you expect
capital requirements to change on average for the two groups of
banks? Will that affect the competitive position of banks not
using the Basel II Advanced Approach?
A.7. As a general matter, the OCC does not believe that the
U.S. implementation of the Basel IA or the Basel II framework
will likely result in a material reduction in aggregate minimum
required capital. However, the relative impact on minimum
capital required for various products and institutions may
differ. One concern with any regulatory change is the
possibility that it might create a competitive advantage for
some organizations relative to others, a possibility that
certainly applies to a change with the scope of Basel II.
The OCC has considered various ways in which competitive
effects might be manifest, and has examined the limited
available evidence related to those potential effects. We
reviewed research on the potential impact on competition in the
residential mortgage market, in small business lending, and in
the credit card market, as well as the potential competitive
effects of introducing explicit capital requirements for
operational risk. We also reviewed research on the issue of
whether Basel II might affect mergers and acquisitions.
Overall, this body of recent economic research does not reveal
persuasive evidence of any sizeable competitive effects. For
many financial products, it is reasonable to think that
competitive effects would be limited; capital is one of many
factors influencing an institution's ability to offer products
competitively. Knowledge of customer needs, knowledge of the
risks associated with the product and with the customer, cost
of funding, and efficiencies of operation all contribute
significantly to an institution's pricing and offering of many
products.
Nonetheless, 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
Basel II. One of our motivations for undertaking the Basel IA
exercise concurrently with Basel II was to reduce potential
competitive effects between large and small U.S. banks by
making improvements to the risk sensitivity of the current U.S.
capital rules. While we believe that the combination of Basel
II and Basel IA will result in limited competitive issues
across the U.S. banking sector, we are very interested in
industry comment on this issue. To facilitate comment, we plan
to have an overlap in the comment periods of the proposals so
that interested parties can look at the capital treatments side
by side in making their assessment of potential competitive
effects.
------ --
----
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM SHEILA C.
BAIR
Q.1.a. Your agency had previously decided that Basel II banks
would be allowed to use only the Advanced Approach. Why did
your agency originally decide not to allow banks to use the
Standardized Approach?
A.1.a. ,When the banking agencies developed the Basel II ANPR
in August 2003, the prevailing view was that only the Advanced
Approaches would be appropriate for large, internationally
active banks. In our judgment there were three main reasons for
this view:
Only the Advanced Approaches were thought
sufficient from a safety and soundness perspective to address
large banks' complex risks;
The largest banks were thought to have robust and
accurate internal risk measurements that would provide a
suitable basis for capital regulation; and
Tying regulatory capital to internal models was
thought necessary to encourage large banks to develop and
refine these models.
Many large banks endorsed these views and encouraged the
development of the Advanced Approaches in their comment letters
to the Basel II ANPR.
Q.1.b. Why have you now decided to re-evaluate this decision?
A.1.b. the FDIC has decided to re-evaluate this issue because
more recent evidence, including the results of the fourth
Quantitative Impact Study (QIS-4), casts doubt on the premises
for the original decision.
Absent significant safeguards, the Advanced
Approaches could undermine banks' safety and soundness by
substantially lowering the bar on capital requirements,
including for the most complex risks.
The robustness and accuracy of internal risk
models is in doubt based on wide dispersion in capital
requirements for similar or identical exposures.
Comment is needed on whether tying internal
models to regulatory capital would improve or interfere with
the evolution of banks' internal capital models for management
purposes.
In addition, a number of core banks, industry trade
associations, regulators, and other commentators have recently
requested that the banking agencies allow banks to compute
their regulatory capital using the Standardized Approach
contained in the international Basel II framework.
Q.1.c. What factors will you consider when deciding whether to
allow banks to use the Standardized Approach? Given that Fed
Chairman Ben Bernanke during his last appearance before the
Banking Committee expressed concerns about whether the
Standardized Approach is appropriate for large, global banks,
is the Standardized Approach a realistic alternative for our
biggest banks?
A.1.c. The FDIC is open to considering some version of the
Standardized Approach as an alternative for any U.S. bank. We
will review the comments on this issue with an open mind.
In reaching a decision on whether to allow banks to use the
Standardized Approach, we will consider the attributes that
need to be present in any regulatory capital system.
A regulatory capital system must require banks to
hold adequate capital to avoid costly draws on the federal
banking safety net. The Standardized Approach avoids the
potential for substantial reductions in bank capital
requirements inherent in the Advanced Approaches.
A regulatory capital system should avoid undue
burden on the banking industry. The Standardized Approach is
simpler and less costly to implement than the Advanced
Approaches.
A regulatory capital system should not tilt the
playing field in favor of one group of banks over another. The
Standardized Approach does not appear to pose the same
potential for competitive inequities across banks of different
sizes as does the Advanced Approaches.
A regulatory capital system should not interfere
with innovation or the evolution of risk management. Some
believe it is necessary to base regulatory capital on internal
models in order to encourage sound risk management. The FDIC
will be attentive to comments on this point.
There also are a number of more technical issues that would
need to be addressed if the banking agencies chose to allow
large internationally active banks to use a version of the
Standardized Approach. A notable example is the issue of
capital requirements for operational risk. The agencies are
seeking comment on how to address this and other technical
issues with the Standardized Approach as we decide whether it
would provide an appropriate framework for capital regulation
in the United States.
Q.2.a. The Basel II NPR has been criticized by several banks
because it deviates from the international Basel II accord by
imposing floors on the amount capital can fall. As a result,
some banks maintain that the Basel II NPR would not be cost
effective for them to adopt. Do you believe that these concerns
about the costs of Basel II as set forth in the NPR are
justified? Could you please give us a comparison of the
estimated costs to implement Basel II versus the expected
benefits of Basel II for a typical bank?
A.2.a. The FDIC believes that the Advanced Approaches of Basel
II would be costly for banks to implement. Some evidence on the
costs of implementation was provided by banking organizations
participating in the QIS-4. As the Office of the Comptroller of
the Currency reported in their Regulatory Impact Analysis, the
average expected cost reported by the QIS-4 banks for
implementing the Basel II rules was approximately $42 million
per bank. However, of that $42 million, banks reported that an
average of $21 million would likely be spent absent the
implementation of Basel II. Therefore, according to QIS-4 data,
the incremental cost of implementing Basel II would average $21
million per bank for the 26 banking organizations participating
in QIS-4. Additionally, the QIS-4 banks estimated that the
recurring annual expense associated with Basel II would average
$2.4 million per year per banking organization. More recent
information suggests these cost estimates may be understated.
The benefits of Basel II are more difficult to quantify.
Some suggest that the ``benefit'' to banks of the Advanced
Approaches is the reduction in capital requirements they would
realize. The FDIC does not believe that substantially reducing
bank capital standards, as compensation for implementing a
costly and burdensome regulatory framework, is wise policy.
From a public policy perspective, a substantial reduction in
bank capital standards could prove to be simply an increase in
the implicit subsidy provided to banks by the federal
government.
Another possible source of indirect financial benefits to
banks that implement Basel II would be if it reduced their
future deposit insurance premiums. Specifically, each bank
might benefit indirectly from a more safe and sound banking
system, by virtue of not having to pay substantial premiums to
cover the cost of resolving problems at a large bank. Whether
the Advanced Approaches would in fact enhance the safety and
soundness of our banks is a key question, and as outlined
above, there are difficult and unanswered questions in this
regard.
Q.2.b. What impact will the deviations from the international
Basel II accord have on the global competitiveness of U.S.
banks?
A.2.b. For 15 years, the U.S. has had in place a dual framework
of capital regulation, consisting of risk-based rules and a
leverage requirement that capital exceed specified ratios of
balance sheet assets. During this 15-year period, U.S. banks
have been required to hold more capital than foreign banks.
There is no indication that our framework of capital regulation
has hurt the competitive position of U.S. banks. Quite the
contrary, our dual framework of capital regulation has
supported the safety, soundness, and resilience of the U.S.
banking system. Our banks enjoy not only strong capital but
high profitability, and there is no evidence that our capital
framework has constrained banks' ability to extend credit.
Going forward, the Advanced Approaches of Basel II clearly
point to reductions in risk-based capital requirements. The
U.S. has proposed safeguards to ensure that such reductions are
moderate and consistent with explicit goals stated in the
international Basel II agreement. Other Basel Committee
countries have no explicit mechanisms to constrain the
potential reductions in their banks' capital requirements. This
opens up the possibility of reductions in capital requirements
for their banks far in excess of what was contemplated in the
international agreement.
This difference in posture is consistent with long-held
U.S. views on the importance of a strong private sector banking
system that does not become a source of economic or fiscal
weakness through over reliance on implicit or explicit safety
net supports. We believe the U.S. approach will ensure that
strong capital will remain a competitive strength of the U.S.
banking system, as it has been in the past.
Q.3. Are banks presently overcapitalized? Please explain how
you arrive at your conclusion.
A.3. No, we do not believe that U.S. banks are overcapitalized.
The level of capital at U.S. banks should be evaluated from
at least three perspectives: their ability to prosper and
compete; their ability to provide credit to fund economic
growth; and the government's interest in avoiding costly draws
on the federal banking safety net. The FDIC does not believe
banks are overcapitalized by any of these standards.
During the 10-year period 1995-2005, FDIC-insured banks'
growth in loans, assets, and net income significantly outpaced
the growth of the broader economy (see table below). Insured
banks have had record profits in 13 of the last 14 years,
topped by the most recent net income of $134 billion in 2005.
This suggests that capital levels have not hindered banks'
ability to prosper and compete or their ability to extend
credit to fund economic growth. :
TABLE A. BANK GROWTH AND PROFITABILITY OUTPACE THE BROADER ECONOMY
[Average annual percent growth in nominal dollars, 1995-2005]
------------------------------------------------------------------------
FDIC-insured institutions U.S. economy
------------------------------------------------------------------------
Assets Loans Net income GDP
------------------------------------------------------------------------
7.5% 7.5% 9.1% 5.3%
------------------------------------------------------------------------
Source: Calculations are based on information from FDIC ``Statistics on
Banking'' (http://www2.fdic.gov/SDI/SOB/) and data compiled by the
Bureau of Economic Analysis.
The FDIC also does not believe banks are overcapitalized
from a safety net protection standpoint. While current industry
capital is adequate, substantial reductions in that capital
would not be prudent from a safety and soundness perspective.
Capital serves an important shock absorber function by ensuring
that unforeseen economic events, significant errors in model
assumptions or accounting methodologies, or other undetected
problems do not cause serious problems for banks. Banking
problems, especially at our largest and most systemically
important banks, can impose costs on the broader economy and
financial system, on the deposit insurance funds, and on the
fiscal position of the U.S. government. Appropriate levels of
bank capital need to reflect the government's interest in
avoiding such costs.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM SHEILA
C. BAIR
Q.1. What is the ratio of tangible equity to assets at the 15
largest bank holding companies? Would it be appropriate to
allow this ratio to drop substantially? What floor, if any,
would you place under this ratio? Should it go below 5%?
A.1. The weighted average ratio of tangible Tier 1 equity
capital to assets for the 15 largest bank holding companies was
4.66 percent as of June 30, 2006.\1\
---------------------------------------------------------------------------
\1\ This number was calculated using the ``Tangible tier 1 leverage
ratios'' as reported on in the Federal Reserve's Bank Holding Company
Performance Report (BHCPR) for each of the top 15 bank holding
companies. In the BHCPR user's guide, the Federal Reserve defines
``Tangible tier 1 leverage ratio'' as ``Tier 1 capital, net of
intangible assets, divided by average assets for the latest quarter,
net of intangible assets.'' This number does not include mortgage
servicing assets, which are intangible assets that may be included in
the Tangible equity ratios of insured depository institutions, subject
to certain limitations. The User's Guide for the Bank Holding Company
Performance Report can be found at http://www.federalreserve.gov/
boarddocs/supmanual/bhcpr_03-05_total_access.pdf. The largest 15 bank
holding companies were determined using the FFIEC list of the largest
bank holding companies, which can be found at http://www.ffiec.gov/
nicpubweb/nicweb/Top50Form.aspx. This list includes both domestic and
foreign-owned bank holding companies operating in the United States.
---------------------------------------------------------------------------
While we believe current industry capital is adequate, the
FDIC does not believe substantial reductions in that capital
would be prudent from a safety and soundness perspective. Our
experience with insured banks is that as core capital measures
begin to fall, the margin for error for both banks and
supervisors can narrow dramatically. The lower a bank's capital
relative to its overall volume of business as measured by
assets, the greater the likelihood that unforeseen economic
events, significant errors in model assumptions or accounting
methodologies, or other undetected problems might create
serious problems for the bank. For a large, systemically
important bank, such problems could have important spillover
costs for the broader economy, the deposit insurance funds, or
the fiscal posture of the United States.
It is therefore appropriate that the agencies have
established floors for certain core capital ratios and that
these floors strictly limit the type and amount of intangible
assets that banks can include in regulatory capital. For
example, to be considered well-capitalized, insured banks must
maintain a ratio of Tier 1 capital to assets of at least 5
percent. Tier 1 capital excludes goodwill, the banking
industry's most significant intangible asset by dollar volume.
Since this question pertains specifically to bank holding
companies, it is important to note that bank holding companies
have different regulatory capital standards than do insured
banks. This includes a less conservative definition of Tier 1
capital and lower requirements for the leverage ratio. Also,
statutory Prompt Corrective Action applies to insured banks,
not bank holding companies. The FDIC does not have any safety
and soundness concern with the current regulatory and
supervisory framework for bank holding companies.
Q.2. We have been led to believe that the goodwill and other
intangibles represent roughly one-third of the U.S. industry's
equity. Is that correct?
A.2. For all FDIC-insured institutions, about one-third of GAAP
equity is composed of goodwill and other intangibles, as
illustrated below.
TABLE B. ABOUT ONE-THIRD OF GAAP EQUITY IS COMPOSED OF GOODWILL AND OTHER INTANGIBLES
[All FDIC-Insured Institutions, June 30, 2006]
----------------------------------------------------------------------------------------------------------------
Percent of equity
----------------------------------------------------------------------------------------------------------------
Total Equity Capital ($ millions)............................. $1,183,807 .......................
Goodwill.................................................. 280,889 23.7%
Other Intangible Assets................................... 109,536 9.3%
-------------------------------------------------
Total Percent of Goodwill and Other Intangible Assets......... ....................... 33.0%
----------------------------------------------------------------------------------------------------------------
Source: FFIEC Quarterly Reports of Condition and Income.
It is important to note that these intangibles make up a
much smaller proportion of regulatory capital, since regulatory
capital does not include goodwill and imposes limits on the
amount of other intangible assets that can be counted as
regulatory capital. For FDIC-insured institutions, 9.43 percent
of Tier 1 capital is composed of intangibles.
Q.3. At this point, only the U.S. and Canada have minimum
leverage ratio requirements. Should U.S. bank regulatory
agencies be comfortable with an international system for bank
capital that does not impose such requirements in other
countries? With the subjectivity involved with the Advanced
Approach of Basel II, does this lack of a leverage ratio
requirement concern you from the perspective of international
financial stability?
A.3. The FDIC is concerned about the lack of explicit
mechanisms in other Basel Committee countries to constrain
potentially substantial reductions in bank capital
requirements. Therefore, the FDIC supports the idea of an
international leverage ratio. A simple capital to assets
measure is a critically important complement to risk-based
capital regulations. The leverage ratio provides U.S.
supervisors with comfort that banks will maintain a stable base
of capital in good times and in bad times. The establishment of
an international leverage ratio would go far in strengthening
the soundness and stability of the international banking system
and would help to ensure that differences in capital
requirements do not lead to competitive inequality among
internationally active banks.
In addition, because the Advanced Approaches of Basel II
clearly point to reductions in risk-based capital requirements,
the U.S. has proposed safeguards to ensure that such reductions
are moderate and consistent with explicit goals stated in the
international Basel II agreement. Most other Basel Committee
countries have no explicit mechanisms to constrain the
potential reductions in their banks' capital requirements. This
creates the possibility of reductions in capital requirements
for their banks far in excess of what was contemplated in the
international agreement.
Our analysis suggests that reductions in bank capital
requirements under the Advanced Approaches could be more
pronounced, by a large margin, than has been reported in any of
the recent quantitative impact studies. There also is a large
and possibly irreducible element of subjectivity in how banks
and supervisors will calculate and validate those capital
requirements.
A substantial reduction in bank capital requirements
worldwide would increase the likelihood of problems in the
global banking system and financial instability. In an
increasingly world-wide economic and financial marketplace, the
U.S. economy and banking system could not expect to be
insulated from problems in the global banking system.
Q.4. The Standardized Approach would (1) be less costly than
the Advanced Approach for both banks and agencies, (2) be less
likely to substantially reduce capital requirements, and (3)
have a lower chance of opening competitive disparities between
U.S. banks of different sizes. Under these circumstances, why
should the agencies not allow such an approach for any U.S.
bank?
A.4. The agencies have sought comment on allowing the
Standardized Approach for any U.S. bank. As noted in the
question, there are a number of attractive features of the
Standardized Approach as compared with the Advanced Approaches.
We also are aware of the argument that only the Advanced
Approaches would adequately encourage the development of risk
management systems at large banks. The FDIC will review the
comments on the availability of the Standardized Approach with
an open mind.
Q.5.a. The Advanced Approach of Basel II has been touted as
addressing safety and soundness concerns related to hidden and
undercapitalized risks that large, complex banks now take under
the current rules. In the results of QIS-4, what was the
aggregate change in minimum risk-based capital requirements:
For securitized exposures?
A.5.a. Observers of the Basel II process frequently point to
securitization as an example of a regulatory capital loophole
not adequately addressed under current rules. However, the
Advanced Approaches would result in lower capital requirements
for these exposures. According to QIS-4 data, minimum required
capital under the Advanced Approaches would fall by
approximately 17.9 percent for securitization exposures.
Q.5.b. For other off-balance sheet exposures?
A.5.b. The QIS-4 exercise suggested that participating banks'
aggregate capital requirement for off-balance sheet exposures
would decline by about 10 percent compared to the current
rules. The QIS-4 data reflected a total decline in capital
requirements for off-balance sheet exposures, despite showing a
significant increase in the capital requirements for over-the-
counter (OTC) derivatives. However, subsequent to the
requirements for over-the-counter (OTC) derivatives. However,
subsequent to the completion of QIS-4, regulators added to
Basel II the expected positive exposure method for computing
capital requirements for OTC derivatives. Recent evidence
suggests that when this new methodology is in place, capital
requirements for OTC derivatives would fall substantially.
Q.5.c. If the current rules are insufficient to address these
complex risks, is it because they require too much capital, or
too little capital?
A.5.c. A frequent criticism of current risk-based capital rules
is that they are ``insufficient'' to address complex risks. It
is not generally understood, however, that the current rules
require, in aggregate, substantially more capital for the
complex risks undertaken by large banks than would be required
under the Advanced Approaches of Basel II.
Q.6. If the goal is to encourage sophisticated risk measurement
and management at our largest banks, why can't they be
encouraged adequately through pillar 2's supervisory guidance
and pillar 3's transparency through public disclosure?
A.6. Large banks measure and manage risk for their own internal
management purposes and supervisors are actively engaged in the
review of these processes. Banks make a substantial volume of
risk-related disclosures in reports filed with both the
Securities and Exchange Commission and the federal banking
agencies. There is a case to be made that bank risk measurement
systems would evolve satisfactorily using the current system of
supervisory review and market disclosures without tying
regulatory capital to these systems. Others believe that the
lack of an explicit regulatory capital calculation based on
banks' internal credit risk estimates would be detrimental to
the long-term evolution of risk-management. This will be an
important issue to resolve, and the FDIC will view the comments
with an open mind.
Q.7. If the mandatory banks operate under the Advanced Approach
and other banks operate under Basel IA, how much do you expect
capital requirements to change on average for the two groups of
banks? Will that affect the competitive position of banks not
using the Basel II Advanced Approach?
A.7. Risk-based capital requirements under Basel II's Advanced
Approaches would probably be much lower than would be available
under Basel 1A, as indicated below.
TABLE C. CREDIT RISK WEIGHTS WOULD FAVOR BASEL II ADOPTERS
----------------------------------------------------------------------------------------------------------------
Risk weights based on:
---------------------------------------------------
Exposure type Basel II advanced
Basel II ANPR (%) QIS–4 (median) (%)
----------------------------------------------------------------------------------------------------------------
Small business loans:
Retail.................................................. 100 61
Other................................................... 100 74
Commercial real estate:
High volatility......................................... 100 70
Other................................................... 100 48
Other commercial............................................ 100 47
Typical 1-4 residential mortgage............................ 35 16
Typical home equity loan.................................... 100 19
Credit cards................................................ 100 117
Other retail loans.......................................... 100 56
AAA-rated Fannie or Freddie MBS............................. 20 7
----------------------------------------------------------------------------------------------------------------
Source: Summary Findings of the Fourth Quantitiative Impact Study and additional calculations.
Notes: Advanced Approaches median risk weights come from Summary Findings of the Fourth Quantitative Impact
Study. Tables B and C. The 7 percent risk weight on Fannie Mae and Freddie Mac mortgage-backed securities is
based on the Basel II NPR proposals. Advanced Approaches capital requirements for credit cards are likely
understated in this table because of the large importance of capital requirements for undrawn lines,
requirements that are not present in the Basel IA ANPR.
Community banks are steadily losing market share in certain
retail lending businesses that are becoming commoditized. For
example, residential mortgage loans, auto loans, and other
consumer revolving credit are becoming scale businesses that
are increasingly dominated by the largest lenders. Community
banks have responded by concentrating increasingly on small
business lending--often the loans are secured by commercial
real estate.
Thus far, the competitive fortunes of banks of different
sizes have been driven by the economics of the various
businesses and not by differences in capital requirements.
There is no precedent, however, for large differences in
capital requirements across U.S. banks such as those
illustrated above. While the competitive effects of these large
differences in capital requirements are unclear, the potential
exists for such differences to cause industry consolidation to
accelerate.
The FDIC believes the capital rules for large and small
banks need to be decided together. One of our important goals
for any overall package of regulatory capital changes is to
avoid tilting the competitive playing field substantially in
favor of one group of banks over another.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM SUSAN S.
BIES
Q.1. Your Agency had previously decided that Basel II banks
would be allowed to use only the Advanced Approach. Why did
your agency originally decide not to use the Standardized
Approach? Why have you now decided to re-evaluate this
decision? What factors will you consider when deciding whether
to allow banks to use the Standardized Approach? Given that Fed
Chairman Ben Bernanke during his last appearance before this
committee expressed concerns about whether the Standardized
approach is appropriate for large, global banks, is the
Standardized approach a realistic alternative for our biggest
banks?
A.1. In the August 2003 Basel II Advance Notice of Proposed
Rulemaking (ANPR), the U.S. banking agencies (Agencies)
proposed (i) to require only the largest, most internationally
active U.S. banking organizations to adopt Basel II and (ii) to
mandate that the largest, most internationally active U.S.
banking organizations adopt Basel II's advanced internal
ratings-based approach to credit risk and advanced measurement
approaches to operational risk. The Agencies decided to take
this limited approach to U.S. implementation of Basel II
because the Agencies felt the Basel II approaches would be too
burdensome for most smaller U.S. banks, and that the Basel II
Standardized Approach would be insufficiently risk sensitive
for the largest, most complex U.S. banks. The comments on the
ANPR generally did not criticize the Agencies for failing to
make available to U.S. banking organizations the simpler
approaches of Basel II, nor did those comments advocate making
the Standardized Approach available to U.S. banks.
Further, the Agencies indicated in October 2005 that they
would make amendments to the existing Basel I-based capital
rule to make it more risk sensitive and to reduce potential
competitive impacts from Basel II. This revised version of
Basel I is now popularly known as Basel IA. The NPR for Basel
IA was just approved by all the agencies for release for
comments. Basel IA is intended to apply to all U.S. banks that
do not use Basel II and gives banks a choice to stay on Basel I
or adopt a slightly more risk sensitive option.
In the spring and summer of 2006, the Agencies received
comment letters from a number of banks, trade associations, and
other interested parties that requested that the Agencies
consider the merits of allowing all U.S. banking organizations
to use the simpler approaches available in Basel II. Because of
the significant interest in the Basel II Standardized
Approaches, the Agencies requested further comment in the Basel
II NPR and Basel IA NPR on whether and, if so, how the Basel II
Standardized Approaches might be applied in the United States.
The Agencies continue to consider this issue and will carefully
consider public input on this question.
Chairman Bernanke has indicated his concern that the Basel
II Standardized Approach would not appropriately reflect the
risks that large, complex, internationally active banks take.
In designing the Basel II Advanced Approaches, banking
supervisors sought to improve the risk sensitivity of our risk-
based regulatory capital framework, remove opportunities for
banks to conduct regulatory capital arbitrage, improve
supervisors' ability to evaluate a bank's capital adequacy,
improve market discipline on banks, and ultimately enhance the
safety and soundness of the banking system. These objectives
cannot fully be met with the Basel II Standardized Approach.
The Basel II Standardized Approach was designed for small,
non-complex, and primarily domestic banking institutions and is
somewhat more risk sensitive than Basel I. It was intended to
be used in those countries where, after the implementation of
Basel II, Basel I would no longer be available. In contrast,
the U.S. Agencies have not expected to eliminate Basel I-based
rules for most of our banks and have not heretofore considered
the Basel II Standardized Approach as an option for U.S. banks
because of the additional costs and only marginal benefits
expected.
In deciding whether to allow our large, internationally
active banks to use the Basel II Standardized Approach, the
Agencies will have to carefully weigh the advantages and
disadvantages of doing so. The disadvantages of Basel II
standardized include (i) limited risk sensitivity--for example,
first lien mortgage loans would generally be assigned a 35
percent risk weight, other retail loans would generally get a
75 percent risk weight, and unrated corporate loans generally
would get a 100 percent risk weight, in each case regardless of
the creditworthiness of the borrower; and (ii) lack of
meaningful connection between capital regulation and risk
management.
Q.2. The Basel II NPR has been criticized by several banks
because it deviates from the international Basel II accord by
imposing floors on the amount capital can fall. As a result,
some banks maintain that the Basel II NPR would not be cost
effective for them to adopt. Do you believe that these concerns
about the costs of Basel II as set forth in the NPR are
justified? Could you please give us a comparison of the
estimated costs to implement Basel II versus the expected
benefits of Basel II for a typical bank? What impact will the
deviations from the international Basel H accord have on the
global competitiveness of U.S. banks?
A.2. The NPR contains a summary discussion of the costs and
benefits of Basel II as part of 'the Executive Order 12866
requirement. In particular, it notes that cost and benefit
analysis of changes in regulatory capital requirements entails
considerable measurement problems. On the cost side, it can be
difficult to attribute particular expenditures incurred by
institutions to the costs of implementation because banking
organizations would likely incur some of these costs anyway as
part of their ongoing efforts to improve risk measurement and
management systems. On the benefits side, measurement problems
are even greater because the benefits of the proposal are more
qualitative than quantitative and as is the case with many
regulations, the benefits accrue to the U.S. society in terms
of a healthier financial system and better risk management at
our largest banking institutions. Measurement problems exist
even with an apparently measurable benefit like lower
regulatory capital requirements because lower regulatory
capital requirements do not necessarily mean that a bank's
actual capital will fall. Healthy banking organizations
generally hold an amount of capital well above regulatory
minimums for a variety of reasons, and the effect of reducing
the regulatory minimum is uncertain and may vary across
institutions.
Among the expected benefits of Basel II are enhanced risk
sensitivity (resulting in more efficient use of regulatory
capital by banks and a reduction in the scope for regulatory
capital arbitrage); a closer relationship between capital
regulation and bank internal risk measurement and risk
management processes; enhanced ability of the regulatory
capital framework to incorporate future product innovation and
future advances in risk measurement and risk management; and
enhanced capacity for supervisory feedback and improved market
discipline. All of these benefits would strengthen the safety
and soundness of the banking organizations subject to the Basel
II NPR and of the U.S. financial system as a whole.
As noted in the Basel II NPR, based on estimates provided
by those institutions that responded to the QIS-4 question on
cost, on average, a banking organization would spend
approximately $42 million to adapt to capital requirements
implementing the Advanced Approaches in Basel II. Not all of
those respondents are likely mandatory institutions. Responses
further indicated that roughly half of organizations' Basel II
expenditures would have been spent on improving risk management
anyway. These numbers should be viewed only as very rough
estimates since not all participants responded, the data are
more than two years old and in many cases were difficult to
compare across institutions due to the qualitative nature of
the responses. However, at this time, no other estimates from
the banks are generally available.
The Basel II NPR includes three transitional floor periods
that would limit the amount by which a bank's risk-based
capital requirements could decline over a period of at least
three years. The Basel II Mid-Year Text issued in July 2005
(New Basel Accord) includes only two transitional years, with
somewhat lower floors. The U.S. transitional floor periods are
designed to provide a smooth transition to the Advanced
Approaches and will help the Agencies evaluate both the overall
functioning of the Advanced Approaches, and the impact of the
Advanced Approaches on specific portfolios and overall capital
requirements, before Basel II becomes fully operational.
Preserving the safety and soundness of the U.S. banking system
is the Agencies' primary motivation for implementing Basel II,
and the transitional floor periods would help ensure that
safety and soundness are maintained as banks transition to the
new capital framework. Similarly, a desire to ensure the
continued safety and soundness of the U.S. banking system
motivated the Agencies' statement in the preamble of the Basel
II NPR that a 10 percent or greater decline in aggregate
minimum risk-based capital requirements, compared to minimum
risk-based capital requirements under the existing rules, would
serve as a benchmark and may warrant modification to the
framework.
Some significant differences do exist between the United
States and other countries in the proposed implementation of
Basel II's Advanced Approaches, beyond the transitional
safeguards. National differences in capital regulation are not
unique to the Basel II capital regime, and some of the existing
differences would carry over into Basel II. For example, the
U.S. banking agencies currently impose a leverage ratio and
Prompt Corrective Action requirements on U.S. banks that are
more conservative than the Basel I capital accord (and would
continue to do so under Basel II), yet U.S. banking
organizations are among the most profitable and competitive in
the world. Nevertheless, early comments on the Basel II NPR
suggest that, whatever the merits of these international
differences in rules, they are likely to add to implementation
costs and raise home-host issues, particularly for globally
active banks operating in multiple jurisdictions. Before the
Federal Reserve issues a final rule, we will carefully consider
any differences in the implementation of Basel II that could
adversely affect the international competitiveness of U.S.
banks.
Q.3. Are banks presently overcapitalized? Please explain how
you arrive at your conclusions.
A.3. My response will focus on the large, complex U.S. banking
organizations that would be subject to Basel II's Advanced
Approaches under the recently issued Basel II NPR. Clearly,
there is a natural tension between the private interests of
these banks in maximizing shareholder profits, on the one hand,
and the public interest in protecting the federal safety net,
maintaining a safe and sound banking system, and promoting
financial stability, on the other hand. As bank regulators, we
seek to strike the right balance between public benefit and
private burden. In particular, it is in no one's interest to
set capital requirements too high, so as to impair the banking
system's financial health, competitiveness, or ability to
efficiently provide the credit and other financial services
necessary for a growing economy, nor too low, so as to
undermine safety and soundness and financial stability.
Within this context, I do not believe that, in the
aggregate, current U.S. regulatory capital requirements are
excessive in relation to banking risks or that the general
level of capital requirements impairs the overall
competitiveness of U.S. banks. In evaluating this issue, one
needs to be careful to appropriately consider the competitive
impact of regulatory capital requirements within the financial
services industry. Competition in this arena is affected by
many factors besides formal regulatory capital requirements,
such as tax policies, economies of scale and scope, risk
management skills, and the ability to innovate. Moreover,
banks' actual capital levels generally exceed the regulatory
minimums by considerable amounts, reflecting not only market
discipline from rating agencies, liability holders, and
counterparties, but also explicit decisions to build capital
buffers in order to weather unanticipated events or facilitate
the pursuit of future investment opportunities.
Some insight into the relationship between regulatory
capital requirements and bank competitiveness is possible by
observing that, even under Basel I, there have been significant
differences in capital regulation across countries. The United
States generally has been viewed as having one of the most
rigorous and conservative capital regimes among major
countries, reflecting the minimum leverage ratio requirement;
prompt corrective action; the definition of regulatory
capital--particularly our insistence that losses be recognized
promptly by banks; and the willingness of the federal banking
Agencies to set risk-based requirements above Basel I levels
for certain higher-risk activities. Significantly, the greater
rigor and conservatism in our capital rules under Basel I does
not appear to have created international competitiveness
problems for our major banking organizations. Quite the
contrary: even though U.S. banks have generally been among the
most strongly capitalized internationally, they are
consistently also among the most profitable.
Nor do strong overall U.S. capital standards appear to
impair the competitiveness of U.S. banks relative to nonbank
competitors. Owing to limited data on profit rates across lines
of business, one cannot directly compare relative profitability
across these institutions on a risk-adjusted basis. However,
research suggests that, at the margin, the federal safety net
provides a significant positive net subsidy for U.S. banks, a
subsidy which obviously is unavailable to nonbanks operating
outside the safety net,\1\ One manifestation of this subsidy is
the ability of large banking organizations to operate with
substantially lower capital ratios than their nonbank
competitors.
---------------------------------------------------------------------------
\1\ See Myron L. Kwast and S. Wayne Passmore, ``The Subsidy
Provided by the Federal Safety Net: Theory and Evidence,'' Journal of
Financial Services Research, Vol. 16, Numbers 2/3, (September/December
1999), pp. 125-146.
---------------------------------------------------------------------------
While the general level of current U.S. capital standards
does not impair the overall competitiveness of our largest and
most complex banking organizations, it would be inappropriate
to conclude that current capital standards provide an adequate
framework for promoting bank safety and soundness. Capital
regulation is the cornerstone of our efforts to maintain a safe
and sound banking system. However, the lack of risk sensitivity
in our Basel I-based capital framework means that it cannot
distinguish between those banks that have taken on greater risk
and those that have not. As a result, current capital rules do
not provide supervisors with an effective framework for
assessing overall capital adequacy in relation to risks, for
judging which institutions are outliers, and for assessing how
capital adequacy may evolve over time. Nor does it provide
banks with appropriate incentives for improving their
measurement and management of risk. The Basel II framework is
intended to address these shortcomings.
------ --
----
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM SUSAN S.
BIES
Q.1. What is the ratio of tangible equity to assets at the 15
largest bank holding companies? Would it be appropriate to
allow this ratio to drop substantially? What floor if any would
you place under this ratio? Should it go below 5%?
A.1. The chart below lists the tangible equity and the tier 1
leverage ratios for the top 15 U.S. owned bank holding
companies (BHCs).
RATIOS FOR TOP 15 U.S. OWNED BHCS, AS OF JUNE 30, 2006
[In percent]
----------------------------------------------------------------------------------------------------------------
Tangible equity ratio%
BHC Tier 1 leverage ratio * **
----------------------------------------------------------------------------------------------------------------
Citigroup................................................... 5.19 4.56
Bank of America............................................. 6.13 3.73
JPMorgan Chase.............................................. 5.85 4.60
Wachovia.................................................... 6.57 4.59
Wells Fargo................................................. 6.99 6.29
U.S. Bancorp................................................ 8.23 5.52
Countrywide................................................. 6.96 7.04
Suntrust.................................................... 6.82 5.88
National City............................................... 6.89 6.66
BB&T........................................................ 7.26 5.50
Bank of N.Y................................................. 6.22 4.99
Fifth Third................................................. 8.38 6.94
State Street................................................ 5.46 4.39
PNC Financial............................................... 7.71 5.24
Keycorp..................................................... 8.82 6.71
----------------------------------------------------------------------------------------------------------------
* Tier 1 Leverage Ratio is equal to regulatory tier 1 capital divided by average total assets.
** Tangible Equity Ratio is equal to GAAP equity, less intangibles (except mortgage servicing assets, which have
an identifiable stream of income), divided by average total assets.
Source: Federal Reserve Y-9C Reports.
Neither U.S. banks nor U.S. BHCs are subject to a minimum
capital ratio based on tangible equity as defined in the chart
above. They are, however, subject to a minimum tier 1 leverage
ratio. While tangible equity and tier 1 capital are similar,
they are not identical. Tier 1 capital includes elements not
included in tangible equity and vice versa. The minimum tier 1
leverage ratio is 3 percent for all BHCs that are rated a
composite ``1'' under the Federal Reserve's BHC rating system
or that have implemented the market risk amendment. The minimum
tier 1 leverage ratio for all other BHCs is 4 percent. Although
banks and thrifts also are subject to a minimum tier 1 leverage
ratio of 3-4 percent, banks and thrifts obtain important
regulatory privileges by maintaining a 5 percent tier 1
leverage ratio in order to be deemed ``well capitalized'' for
purposes of the prompt corrective action framework and the
financial holding company provisions of the Gramm-Leach-Bliley
Act. Prompt corrective action does not apply to BHCs, so there
is no ``well capitalized'' tier 1 leverage ratio threshold.
The Federal Reserve believes that constraining the overall
leverage of a BHC helps ensure that the holding company does
not pose a threat to the financial health of its subsidiary
insured depository institutions.
The BHC supervision manual directs examiners to consider a
BHC's tier 1 leverage ratio as a supplement to its risk-based
capital ratios when assessing the BHC's capital adequacy.
However, the tier 1 leverage ratio is only one of several
indicators used to assess the capital strength of a BHC and
should not be used in isolation. For example, Federal Reserve
examiners also analyze the composition and quality of the BHC's
capital instruments, the BHC's asset quality, and the BHC's
exposure to interest rate risk, concentration risk, liquidity
risk, and operational risk. Depending on all the factors that
Federal Reserve staff takes into consideration when reviewing
the capital adequacy of a BHC, a tier 1 leverage ratio below 5
percent could be acceptable for certain BHCs while for other
BHCs a tier 1 leverage ratio above 5 percent could be
appropriate.
Q.2. We have been led to believe that the goodwill and other
intangibles represent roughly one-third of the U.S. industry's
equity. Is that correct?
A.2. Intangibles, including goodwill but excluding mortgage
servicing assets, which have an identifiable stream of income,
represent approximately 30 percent of the total equity of U.S.
commercial banks. (See chart below.)
U.S. COMMERCIAL BANKS INTANGIBLES TO EQUITY DATA AS OF JUNE 2006
----------------------------------------------------------------------------------------------------------------
Weighted average% of
Group of banks Number of banks intangibles to equity
----------------------------------------------------------------------------------------------------------------
Under $250m................................................. 5,584 4.83
$250m-$500m................................................. 994 6.87
$500m-$1b................................................... 495 13.77
$1b-$5b..................................................... 342 20.11
Greater than $5b............................................ 144 35.55
---------------------------------------------------
All Banks............................................... 7,559 30.53
----------------------------------------------------------------------------------------------------------------
Almost all of these intangibles are deducted from the
calculation of regulatory Tier 1 capital, as are excess amounts
of mortgage servicing assets. The vast majority of intangibles
are in the form of goodwill and, as a result, intangibles are
greater as a percentage of equity in the larger banks, which
have been most active in acquisitions. As long as tangible
capital levels are strong, a significant percentage of
intangibles to capital does not pose a supervisory concern.
Q.3. At this point, only the U.S. and Canada have minimum
leverage ratio requirements. Should U.S. bank regulatory
agencies be comfortable with an international system for bank
capital that does not impose such requirements in other
countries? With the subjectivity involved with the Advanced
Approach of Basel II, does this lack of a leverage ratio
requirement concern you from the perspective of international
financial stability?
A.3. The Basel Committee and national authorities will continue
to monitor the impact of Basel II Pillar 1 capital requirements
during the transition period of the Basel II framework and
thereafter. Countries on the Basel Committee indeed want to
ensure as much consistency as possible in implementing Basel
II, and obviously agree on the goal of promoting financial
stability more broadly. However, there are important legal,
market, and cultural differences across countries that require
a certain amount of national discretion for the Basel II
framework to be suitable for each individual country. This is
not a new development; national discretion has been applied
since the initial implementation of Basel I, and many
differences exist today across countries in the application of
capital rules.
In all Basel member countries, Basel II's Pillar 1 risk
based capital standard is being implemented in conjunction with
other measures under Pillars 2 and 3 to ensure that banks
maintain adequate capital levels. Some countries impose
supplementary minimum capital standards, such as the leverage
ratio requirements imposed by the United States and Canada.
However, other countries employ different approaches, tailored
to their specific institutional and supervisory regimes to
ensure their comfort with banks' overall capital levels.
Because Basel member countries are committed to identifying
potential differences across countries in their capital
adequacy frameworks and the potential effects of those
differences, members of the Accord Implementation Group (AIG)
are sharing information on supervisors' Pillar 2 techniques to
assess banks' capital cushions over the regulatory minimum. In
this context, the AIG is collecting information on a variety of
supplementary measures of capital adequacy that members may be
employing in their jurisdictions, and plans to report back to
the Committee. In the case of the United States, the leverage
ratio has served as a very valuable complement to the risk-
based capital rules, and we believe it should continue to do so
under Basel II.
Q.4. The Standardized Approach would (1) be less costly than
the Advanced Approach for both banks and agencies, (2) be less
likely to substantially reduce capital requirements, and (3)
have a lower chance of opening competitive disparities between
U.S. banks of different sizes. Under these circumstances, why
should the agencies not allow such an approach for any U.S.
bank?
A.4. The financial costs to a bank associated with implementing
a much more simplistic framework would be lower than under the
Advanced Approaches. But many of the costs being incurred by
banks under the auspices of the Basel II Advanced Approaches
are in our view costs associated with improving risk management
more generally. In fact, the desire to avoid unnecessary
regulatory costs is one reason why we have limited the number
of banks that are required to be on Basel II and have tried to
build Basel II on what banks are already doing. In contrast,
the Standardized Approach bears little resemblance to what
large, complex banks actually do to manage their risk.
The concern that Basel II will unfairly tilt the
competitive playing field is something that we and the other
U.S. agencies take very seriously. Some have argued that the
bifurcated application of Basel II within the United States
could allow domestic banks that adopt the framework both lower
minimum required capital charges on certain activities and
lower minimum required capital requirements compared with other
domestic banks. Lower minimum required capital charges would,
it has been argued, translate into a cost advantage for
adopters that would place non-adopters at a competitive
disadvantage. In addition, some fear that adopters would use
any newly created excess regulatory capital to acquire smaller
banks.
In part to address these concerns, the banking agencies
proposed revisions to the existing Basel I-based capital rules
(so-called Basel IA) that would aim to mitigate potential
competitive inequities. Furthermore, we want to emphasize that
during the comment period for Basel II and Basel IA NPRs, we
urge interested parties to give us specific advice regarding
what else we may need to do to reduce any unintended
consequences of Basel II.
The Basel II Standardized Approach was designed for small,
non-complex, and primarily domestic banking institutions and is
somewhat more risk sensitive than Basel I. It was intended to
be used in those countries where, after the implementation of
Basel II, Basel I would no longer be available. In contrast,
the U.S. Agencies have not expected to eliminate Basel I-based
rules for most of our banks and have not heretofore considered
the Basel II Standardized Approach as an option for U.S. banks
because of the additional costs and only marginal benefits
expected.
In deciding whether to allow our large, internationally
active banks to use the Basel II Standardized Approach, the
Agencies will have to carefully weigh the advantages and
disadvantages of doing so. The disadvantages of Basel II
standardized include (i) limited risk sensitivity--for example,
first lien mortgage loans would generally be assigned a 35
percent risk weight, other retail loans would generally get a
75 percent risk weight, and unrated corporate loans generally
would get a 100 percent risk weight, in each case regardless of
the creditworthiness of the borrower; and (ii) lack of
meaningful connection between capital regulation and risk
management.
In the Standardized Approach, the relatively crude method
of assigning risk weights to assets, as well as an emphasis on
balance-sheet risks as opposed to other risks facing financial
firms, limits the overall responsiveness of capital
requirements to risk, which renders that framework inadequate
for supervising the largest and most complex banking
organizations. It is quite telling that none of the largest
foreign institutions signaled an intention to adopt the
Standardized Approach in the QIS-5 study (see below).
----------------------------------------------------------------------------------------------------------------
Number of observations in each cell classified as ``most Standardized
likely'' approach FIRB approach AIRB approach
----------------------------------------------------------------------------------------------------------------
G10 Group 1.................................................. 0 23 33
----------------------------------------------------------------------------------------------------------------
Source: Federal Reserve calculations based on ``Results of the Fifth Quantitative Impact Study,'' Table 3, BCBS
Note: Group 1 consists of the largest institutions, namely those that have tier 1 capital in excess of =3bn, are
diversified, and are internationally active. This table differs from the one in the BCBS study in that US
banks are excluded.
Q.5. The Advanced Approach of Basel II has been touted as
addressing safety and soundness concerns related to hidden and
undercapitalized risks that large, complex banks now take under
the current rules. In the results of QIS-4, what were the
aggregate changes in minimum risk-based capital requirements
for (a) securitized exposures, and (b) other off-balance sheet
exposures? If the current rules are insufficient to address
these complex risks, is it because they require too much
capital, or too little capital?
A.5. Relative to the current risk-based rules, the aggregate
QIS-4 change in minimum required risk-based capital (MRC) for
securitization exposures was -17.9%, while that for all other
off-balance sheet exposures (including operational risk) was
+40.3%. In addition to the general caution that should be
exercised when interpreting QIS-4 results, several specific
factors should be considered in the context of results for
securitization exposures and other off-balance sheet exposures.
Special Considerations When Interpreting QIS-4 Results for
Securitization Exposures
First, with regard to securitization exposures, it should
be noted that some key elements of the Basel II treatment are
already incorporated into the current risk-based capital rules
as a result of revisions the agencies made to the U.S. rules in
2001 to address risk sensitivity and capital arbitrage
concerns. These revisions were not adopted at the time by other
countries, implying that U.S. banks faced more conservative
risk-based capital charges against most securitization
exposures than their foreign competitors. With the adoption of
Basel II, the U.S. and foreign treatments for securitization
exposures will be brought into alignment. Based on QIS-5
results, it is estimated that the Basel II treatment of
securitization exposures will produce approximately a 10%
increase in risk-based capital charges for non-U.S. Group I
banks, relative to Basel I.
Second, most of the -17.9% change in risk-based capital
charges for securitization exposures in QIS-4 appears to
reflect lower risk-weights under Basel II, compared to the
current rules, for very highly-rated (e.g., AAA or AA) asset-
backed securities held mainly in banks' securities (ABS)
portfolios. In QIS-4, this category also included residential
mortgage-backed securities issued by Fannie Mae and Freddie
Mac. Under Basel II, these very low-risk ABSs typically receive
risk-weights ranging from 7% to 15%, compared with 20% under
current risk-based capital rules. These Basel II risk-weights
will better reflect the actual credit risks of these ABSs, and
will provide more appropriate risk-based capital incentives for
banks to hold low-risk securities and maintain adequate
liquidity. While below-investment-grade ABSs will receive much
higher capital charges under Basel II compared to current
rules, the QIS-4 respondents held relatively small amounts of
such instruments.
Lastly, the QIS-4 results do not reflect changes proposed
in the recently issued Market Risk NPR that would increase
risk-based capital charges for certain (unrated) high-risk,
illiquid securitization exposures held in trading accounts.
These revisions are intended, in part, to close an emerging
loophole in our capital rules. In recent years, some banks have
shifted such positions from the banking book to the trading
account, where they currently incur much lower capital
requirements.
Special Considerations When Interpreting QIS-4 Results for Other Off-
Balance Sheet Exposures
With regard to off-balance sheet exposures (excluding
securitization exposures) the aggregate 40.3% increase in
estimated MRC under Basel II was driven largely by the
operational risk capital charge. Operational risk is one of the
most important of the hidden, off-balance sheet risk for which
there is no explicit capital charge under the current risk-
based capital rules. The estimated change in off-balance sheet
credit exposures alone was -10.0%; inclusive of the 1.06
multiplier this change would have been around -5.3%.
Q.6. If the goal is to encourage sophisticated risk measurement
and management to our largest banks, why can't they be
encouraged adequately through Pillar 2's supervisory guidance
and Pillar 3's transparency through public disclosure?
A.6. Pillar 2 and Pillar 3 are indeed vitally important
elements of the Basel II framework, and should not be
overlooked. Their value is enhanced and strengthened by linking
them with the advanced Pillar 1 approaches. Key advantages of
the advanced Pillar 1 approaches of Basel II are that they: (i)
encourage improvements in risk measurement and management at
the participating banking institutions; (ii) facilitate the
integration of minimum regulatory capital requirements with
internal risk measurement and management processes; and (iii)
provide a common risk measurement and management vocabulary for
banks and supervisors to use. Another key objective of Basel II
is to improve risk sensitivity of risk-based capital
requirements at the largest U.S. institutions.
In developing the Basel II NPR, the U.S. agencies did
consider whether they should simply encourage risk management
improvements at these large institutions and not tie those
practices directly to regulatory capital. But it became clear
that for safety and soundness reasons the relative riskiness of
these banks' positions needed to be included in minimum
regulatory capital measures, that is, in the advanced Pillar 1
approaches. Just looking at risk measurement practices and
models (Pillar 2) does not provide the appropriate backstop
that actual capital does; in turn, minimum required capital
measures at the largest institutions lack meaning when they are
not risk sensitive. Additional disclosure of risk measurement
and management (Pillar 3) without a discussion of the advanced
Pillar 1 approaches would not necessarily represent an
improvement over traditional risk management disclosures. We
believe the Pillar 1 measures, when complemented by Pillars 2
and 3, provide a sound framework for bankers, supervisors, and
market participants to assess how capital and risk evolve over
time.
Q.7. If the mandatory banks operate under the Advanced Approach
and other banks operate under Basel IA, how much do you expect
capital requirements to change on average for the two groups of
banks? Will that affect the competitive position of banks not
using the Basel II Advanced Approach?
A.7. At this point in the implementation process, we cannot
estimate accurately what the average change in capital
requirements would be for banks operating under the Basel II
Advanced Approaches and those operating under Basel IA. As you
know, the Basel II proposal is now in the formal comment
period. Under current implementation plans, we have overlapping
comment periods for the two proposals so that commenters will
be able to assess the potential effect of both proposals on
their minimum required capital positions and provide meaningful
information to the agencies about the overall impacts of the
proposals as well as identify areas of potential competitive
pressure.
As we review and analyze public comments on both proposals,
one objective we will keep in mind is to mitigate, to the
extent possible, areas of demonstrated negative competitive
impact. However, we must also keep in mind the fundamental
point that the Basel II Advanced Approaches are designed to be
as risk-sensitive as possible and the Basel IA proposal
currently under interagency discussion is intended to fit
within the structure of the existing broad-brush risk-based
capital framework without imposing undue regulatory burden on
smaller financial institutions. It is inevitable that under the
two frameworks similar exposures may be subject to different
minimum risk-based capital charges. As we move forward with
implementing Basel II, we will continue to be mindful of
potential competitive concerns and will propose and implement
modifications to our capital rules as appropriate to address
competitive issues.
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Sec. Sec.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM DIANA L.
TAYLOR
Q.1. The Advanced Approach of Basel II has been touted as
addressing safety and soundness concerns related to hidden and
undercapitalized risks that large, complex banks now take under
the current rules. In the results of QIS-4, what was the
aggregate change in minimum risk-based capital requirements for
securitized exposures? For other off-balance sheet exposures?
If the current rules are insufficient to address these complex
risks, is it because they require too much capital, or too
little capital?
A.1.
Securitized Exposures
The Banking Department (like other members of CSBS) has
only seen the public report on the QIS-4 results, so we can't
provide any new information about the changes in minimum risk-
based capital requirements for securitized exposures found in
QIS-4. The paper, ``Summary Findings of the Fourth Quantitative
Impact Study,'' released by the federal agencies in February
2006, includes little specific mention of changes in capital
for securitized assets, but does show weighted average and
median changes in required capital in Table 4. The weighted
average change in minimum regulatory capital for securitized
assets at the QIS-4 banks was -17.9%, and the median change was
-39.7%. However, there is no discussion of these median and
average changes, nor of the types of securitized assets held by
QIS-4 banks, in the text of the paper.
Basel II proposes three different approaches to calculating
capital for securitization exposures: the Ratings-Based
Approach (RBA) for securitizations with external ratings, the
Internal Assessment Approach (IAA) and the Supervisory Formula
Approach (SFA) for unrated securitizations. Banks allowed to
use the IAA approach map their own assessments of the credit
risk of their securitization exposures to external ratings and
then use the RBA risk weights. The reduction in risk-weighting
for investment-grade rated securitizations, and those with
inferred investment grade ratings, is significant under Basel
II:
REPRESENTATIVE RISK WEIGHTS FOR SECURITIZATIONS WITH EXTERNAL RATINGS (OR INFERRED RATINGS)
----------------------------------------------------------------------------------------------------------------
Basel II RBA--senior positions Basel II RBA--
Long-Term rating Current (%) (%) base (%)
----------------------------------------------------------------------------------------------------------------
AAA 20 7 12
AA 8 15
----------------------------------------------------------------------------------------------------------------
A+ 50 10 18
A 12 20
A- 20 35
----------------------------------------------------------------------------------------------------------------
BBB+ 100 35 50
BBB- 60 75
BBB 100 100
----------------------------------------------------------------------------------------------------------------
BB+ 200 250 250
BB 425 425
BB- 650 650
----------------------------------------------------------------------------------------------------------------
Below BB- Deduct Deduct Deduct
----------------------------------------------------------------------------------------------------------------
If most of the securitizations held by the QIS-4 banks were
at least investment grade or could be inferred to be at least
investment grade, then it is clear that these banks would
report significant declines in required capital for their
securitization portfolios. As mentioned above, the QIS-4 report
contains no information about the portfolio breakdown for
participating banks, although the QIS-4 worksheets and
questionnaire requested extensive information about banks'
securitized asset portfolios: for example, the exposures for
which each of the three capital calculation methods apply, the
amount of credit risk mitigation (collateral and guarantees)
that banks applied to each exposure type, and the amount of
exposures that the early amortization requirement applied to.
It is very difficult to understand the impact of the changes in
capital treatment for securitizations without access to
information from the QIS-4 submissions, and CSBS has requested
such access.
Some evidence of banks' securitization holdings can be
found in the current Call Report, as banks report BB-rated
securitization amounts as a negative number on Schedule RC-
R.\1\ We don't know which banks participated in the QIS-4, but
presumably the banks identified by the OCC as meeting the
definition of mandatory bank \2\ were among the participants.
Reviewing the June 30, 2006, Call Reports for the ten banks
identified by the OCC suggests that few of their securitized
assets had low ratings, as only two of these banks show
evidence of possibly holding securitizations rated BB. In both
cases, the amount indicated as possibly representing BB-rated
securitizations was less than 5% of total privately issued
securitizations. (The breakdown of deducted assets cannot be
determined from the Call Report alone, as different types of
deductions are lumped together.) The federal agencies have
collected information that enables them to describe in detail
the securitization portfolio at each of the 26 QIS-4 banks;
understanding these portfolios is essential to interpreting the
impact of Basel II.
---------------------------------------------------------------------------
\1\ Banks report as a negative number the amortized cost of
mortgage-backed and asset-backed securities that are rated one grade
below investment grade in item RC-R 35 Col. B and RC-R 36 Col. B., in
addition to the difference in fair value and amortized cost of their
other securities. These items indicated securities rated BB in only two
cases.
\2\ ``Regulatory Impact Analysis for Risk-Based Capital Standards:
Revised Capital Adequacy Guidelines,'' http://www.occ.treas.gov/law/
Basel%20II%20RIA.pdf
---------------------------------------------------------------------------
Banking Department
It seems unlikely that the banks that participated in QIS-4
are currently holding large positions in poorly rated
securitizations or unrated securitizations for which they are
unable to infer ratings. The median change in capital
requirements for securitization was -39.7%, and it is hard to
see how this decline would have resulted if there had been
sizeable holdings that received double or triple risk-
weighting, or had to be deducted. It seems probable that large,
complex banks already tend to hold securitizations rated at
least investment grade (or that can be inferred to be
investment grade), and the net effect of Basel II on their
securitization portfolio will be to reduce capital
requirements. Basel II might even have the perverse effect of
allowing banks to hold a greater percentage of poorly rated or
unrated securitizations without increasing required capital,
since the risk weights for investment-grade rated securities
are so much lower than currently.
The concept behind Basel II's treatment of securitization
is very close to that of current U.S. treatment. The major
differences are in particular risk weight specifications and in
allowing banks to use the Supervisory Formula Approach for some
securitizations that previously would have been deducted from
capital. It seems probable that the framers of Basel II felt
that current treatment is inadequate because banks are required
to hold too much capital for their securitization exposures.
More detailed information about the QIS-4 securitization
portfolios would help in determining if this is so.
However, it's interesting to note that the impact of Basel
II's treatment of securitization varies widely across countries
that are adopting it, as current rules are very different. For
example, German QIS-4 results included an increase of 153% in
required capital for participating Group 1 banks (those with
more than 3 billion euros in tier 1 capital) using the Advanced
IRB approach. \3\ The Basel Committee's release \4\ on results
of QIS 5 reported that ``The average change in minimum required
capital from the securitisation portfolio for G10 Group 1 banks
varies between -42% and +60% for the IRB approach. This seems
to be the result of different types of positions and
differences in current national regulations. Some countries
have already under their current national regulation a stricter
treatment than the current Accord provides (this affects in
particular liquidity facilities and retained securitisation
positions).'' The U.S. is clearly one of these countries.
---------------------------------------------------------------------------
\3\ http://www.bundesbank.de/download/bankenaufsicht/pdf/qis4/
basel_qis_ laenderbericht_dt.pdf
\4\ http://www.bis.org/bcbs/qis/qis5results.pdf
---------------------------------------------------------------------------
The Department is also concerned with the potential
incentives presented to banks through the Basel II revisions. A
paper released last year by Fitch Ratings \5\ discussed some of
the capital incentives contained in Basel II's treatment of
securitized exposures. This report was published before the
federal agencies released the Basel II NPR, which included
changes in the treatment of securitized exposures from the
earlier ANPR, but Fitch Rating's analysis of the Basel II
treatment of a sample portfolio of securitizations is still
relevant. Fitch analysts found that Basel II banks would have
differing incentives to securitize assets depending on
portfolio type, and that Basel II could lead to inconsistencies
in capital charges across different securitization deals and
might influence deal structuring. These potential consequences
need serious consideration before Basel II is implemented.
---------------------------------------------------------------------------
\5\ ``Basel II: Bottom-Line Impact on Securitization Markets,''
FitchRatings, September 12, 2005, www.fitchratings.com
---------------------------------------------------------------------------
Other Off-Balance Sheet Exposures
The QIS-4 results reported in the Summary paper include the
effects of credit risk mitigation, and group all types of
exposure (both on- and off-balance-sheet exposures) so it is
difficult to determine aggregate changes in capital
requirements for off-balance sheet exposures. Although the A-
IRB approach of Basel II requires banks to hold capital for
undrawn commitments for which current requirements impose a 0%
risk weight, this approach also allows banks to calculate
capital based on their own estimation of the actual exposure at
default, probability of default, and loss given default. In
addition, Basel II includes a much broader recognition of the
credit risk mitigation afforded by off-balance sheet exposures.
The QIS-4 Summary paper provides too limited information to
allow us to determine the impact on off-balance sheet
exposures. The federal agencies have reported summary
statistics for credit conversion factors (CCF) for the exposure
at default (EAD) for undrawn lines in different portfolios, but
have not reported PDs or LGDs for these undrawn lines, nor have
they reported the exposure at default credit conversion factors
for drawn lines, so comparison of on-balance sheet and off-
balance sheet exposures is almost impossible. Again, the QIS-4
templates and questionnaire requested extensive information on
off-balance sheet positions, and their use as credit mitigants.
More detailed information on the QIS-4 results would allow us
to determine the impact of Basel II on these exposures.
The federal agencies did state, \6\ however, that one of
the factors that might have caused minimum capital requirements
in QIS-4 to be understated was ``the lack of incorporation of
credit risk mitigation.'' Further, they state, ``The Agencies
expect that as we move closer to implementation, systems will
capture the information necessary to permit the assignment of
lower risk weights to these exposures.''
---------------------------------------------------------------------------
\6\ http://www.federalreserve.gov/boarddocs/press/bcreg/2006/
20060224/qis4_attachment_ revised.htm
Q.2. If the goal is to encourage sophisticated risk measurement
and management at our largest banks, why can't they be
encouraged adequately through pillar 2's supervisory guidance
---------------------------------------------------------------------------
and pillar 3's transparency through public disclosure?
A.2. We believe that supervisory guidance and public disclosure
have proven to be very effective methods of encouraging
improvements in risk management. Many institutions have found
market recognition of sophisticated risk management a very
valuable goal. We have utilized ``best practices'' discussions
and supervisory guidance papers to help banks develop
improvements in their risk management and modeling systems.
Encouraging improvement is an integral part of supervision,
either through peer analysis, benchmarking, or consultation.
One of the complaints we hear from banks about Basel II is
that the federal agencies have not released supervisory
guidance on implementation, and this complaint highlights the
need for Pillar 2. Another complaint that we've heard is that
the Basel II supervisory formulas aren't appropriate for large
complex banking institutions. Promoting improvements in risk
management through Pillar 2 and Pillar 3 would have the
advantages of allowing banks to pursue the quantitative
modeling and data collection that best fits their own risk
profile and allowing supervisors to assess each bank's system
without imposing constraints on their modeling efforts.
Advanced research and data collection in credit and operational
risk modeling are so new that development in this field might
be improved if banks were not constrained by the Basel II
supervisory models. However, supervisors would have to be
assured that safe and sound capital requirements remained in
place while this development took place.
Q.3. If the mandatory banks operate under the Advanced Approach
and other banks operate under Basel IA, how much do you expect
capital requirements to change on average for the two groups of
banks? Will that affect the competitive position of banks not
using the Basel II Advanced Approach?
A.3. We believe that overall risk-based capital requirements
will fall at the mandatory banks, and are convinced that
transitional floors and safeguards are necessary. Although the
reductions in risk weights proposed under Basel IA are in some
cases similar to the weighted average changes reported by the
QIS 4 banks--QIS-4 banks reported a weighted average reduction
in minimum capital requirements for small business loans of
26.6% and Basel IA suggests reducing the risk weight for small
business loans to 75% from 100%, a drop of 25%--in other
portfolios, the weighted average change is much greater for QIS
4 banks. For example, QIS-4 banks reported a weighted average
decrease in minimum regulatory capital for residential
mortgages of 61.4% and a weighted average decrease of 74.3% for
home equity loans.
Our survey \7\ of the change in capital requirements at
several New York banks under Basel IA proposed risk weights,
however, produced an estimate of 34% as the average risk weight
for the banks residential mortgage portfolio, or a reduction of
30% from current risk weights. And even in the cases where
Basel IA suggests a lower risk weight, the restrictions
attendant on using the new risk weight are much greater than
under Basel II. A case in point is the treatment of home equity
loans, where Basel IA banks can only apply a risk weight based
on LTV or other risk factors if the bank holds both first and
junior liens. There is no such restriction for Basel II banks.
It is unlikely that Basel IA banks will have many externally
rated borrowers for commercial real estate loans; thus these
loans will probably be risk-weighted at least at 100%. However,
the weighted average change in minimum required capital for the
riskiest commercial real estate loans at QIS 4 banks was a
reduction of 33.4%.
---------------------------------------------------------------------------
\7\ http://www.banking.state.ny.us/rp0605.pdf
---------------------------------------------------------------------------
There is a great danger that if mandatory banks are allowed
to hold less risk-based capital than Basel IA banks, then these
IA banks will be at a competitive disadvantage. We believe that
Basel IA banks and mandatory banks do compete in many of the
same markets and offer many of the same products. Seven of the
ten banks identified as meeting the definition of mandatory
bank by the OCC have branches in New York State; these branches
accounted for 33% of New York insured bank branches and held
58% of total insured deposits in the state as of June 30, 2006.
Nine of the ``mandatory'' banks reported originating small
business loans to New York addresses in their 2005 CRA
reports--these nine banks reported a significant share--close
to half--of total small business loans reported in the state.
We are well aware of the many services and products these banks
provide for New York residents. However, we are uneasy when one
group of banks with already substantial market power is
provided--through regulation--with a competitive advantage over
smaller banks that they compete with. We are particularly
concerned when a substantial part of their capital advantage--
much lighter risk weights for retail loans--comes from the
great volume of their retail loan portfolios. Smaller banks
cannot compete in volume with the large retail banks.
In the U.S., if the large Basel II banks have an advantage
over the smaller banks because their cost structure is so much
more attractive, this could push acquisition of regional and
community banks by the Basel II banks. Increased acquisition of
Basel IA banks could leave local communities, which rely on
their local banks for products and services that meet their
specific needs, with access to a limited number of bank
products; we could find ourselves in a situation in which it is
no longer profitable to provide a range of financial services
to small businesses in smaller communities.
In other words, a business model in which smaller banks, by
design, are at a competitive disadvantage to Basel II banks
could have a significant negative impact on small businesses in
the U.S.--the backbone of our economy. The impact of Basel II
on competition in U.S. banking markets must be seriously
assessed before implementation goes forward.
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