[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


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                            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

                              ----------                              

                      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

                              ----------                              


                      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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