[Congressional Record (Bound Edition), Volume 151 (2005), Part 4]
[Extensions of Remarks]
[Pages 5681-5682]
[From the U.S. Government Publishing Office, www.gpo.gov]




                    JOHN LaFALCE'S VIEWS ON BASEL II

                                 ______
                                 

                           HON. BARNEY FRANK

                            of massachusetts

                    in the house of representatives

                         Tuesday, April 5, 2005

  Mr. FRANK of Massachusetts. Mr. Speaker, my predecessor as the 
Ranking Minority Member of the Committee on Financial Services, John 
LaFalce, made enormous contributions during his tenure in Congress to 
our deliberations on financial services issues, and as a private 
citizen, he continues to do so. I have myself benefited in a number of 
conversations from his knowledge and wisdom about a range of issues. 
One of those about which he is most concerned is the current plan for a 
change in international financial regulations known as Basel II. On 
March 11, John LaFalce published a very thoughtful, well-informed 
article in the American Banker, outlining his concerns about the 
implications of Basel II. This is a subject currently before us in the 
Financial Services Committee, and while not widely known, is of great 
importance to our financial system. Because of that, I ask that the 
article by John LaFalce expressing his deep reservations about Basel II 
be printed here.

                Basel II Plan is a Crisis in the Making

       In the coming year Congress and U.S. bank regulators will 
     decide whether to adopt new capital regulations that would 
     impact the entire U.S. banking system.
       Current discussions about Basel II are focusing on the 
     minute details, rather than the more important question of 
     whether the proposed accord makes any sense at all. In my 
     view, Basel II is fundamentally flawed, and actually 
     dangerous, for numerous reasons.
       First, it is based on a fanciful premise that sophisticated 
     risk-management models enable banks to allocate capital to 
     each asset that is neither too low, nor too high, but just 
     right. I hope my former colleagues and others do not gamble 
     the stability of our domestic and global financial system on 
     this theory.
       Recent financial crises, such as at Long-Term Capital 
     Management, should serve as stark reminders that all models, 
     no matter how sophisticated, are subject to unpredictable 
     market forces and, most important, human judgments, mistakes, 
     and even manipulation.
       With every large bank in the world lining up to play the 
     Basel II capital game, and a financial system that is 
     increasingly interdependent, the consequences of even an 
     inadvertent mistake could be devastating. The odds are too 
     high that Basel II, if adopted, could trigger a systemic 
     financial crisis.
       Second, Basel II's proponents have been too quiet about the 
     most fundamental tenet of banking regulation--safety and 
     soundness--and the critical role that an adequate capital 
     cushion plays in the safe and sound operation of our banks 
     and banking system. A Basel II regime would be reckless, 
     unsafe, and unsound, inter alia, because:
       It would allow banks to use complex risk-based models that 
     few if any corporate executives or directors will ever 
     comprehend adequately, if at all, and models that the 
     regulators will lack the resources and technical skills to 
     supervise adequately.
       It is an ominous sign that the regulators recently 
     published a formula that would have caused banks to 
     underestimate their capital needs for retail credits by 60 to 
     70%.
       Banks will implement Basel II only if they know their 
     capital requirements will decline. That will also create 
     powerful incentives, competitive pressures, and irresistible 
     temptations for the nation's largest banks to revise their 
     models over time to achieve the lowest amount of capital 
     reserves possible.
       Banks will be able to artificially improve their 
     performance by manipulating capital levels, much as we have 
     seen some companies manipulate earnings.
       The new capital regime will seriously undermine the 
     competitive viability of small to medium-size banks because 
     of the dramatically lower capital levels that the largest 
     banks will achieve. We now know that two former Federal 
     Reserve economists came to that very conclusion in a paper 
     that is being published independently.
       Third, Basel II is overly optimistic about the ability and 
     resources of regulators to supervise the new and complex 
     capital rules. As Standard & Poor's has pointed out, 
     ``National bank regulators could be overwhelmed by the 
     implementation of Basel II, with its intensive need for 
     verification of the internal systems and databases of 
     individual banks.''
       In addition, although the new accord allows regulators to 
     make discretionary capital adjustments, banks will likely 
     resist or seek to influence these adjustments, particularly 
     after spending tens and even hundreds of millions of dollars 
     developing their models.
       As for market oversight, I discount that almost entirely. 
     We are already seeing resistance by banks to making public 
     disclosures about their models, ostensibly because of concern 
     over the potential litigation exposure. Neither the markets 
     nor the regulators nor most corporate officers or directors 
     will be in any position to comprehend the underlying 
     assumptions and idiosyncrasies built into the banks' models 
     or to react quickly enough to emerging crises.
       Fourth, some in the Federal Reserve would like us to 
     believe that adoption of Basel II is necessary and 
     inevitable. It is neither. Despite the perceived momentum 
     behind Basel II, the accord seems to have little support 
     beyond a few forceful players at the Federal Reserve and the 
     handful of the largest banks that stand to gain the most 
     because of reduced capital requirements.
       I am convinced that the seasoned executives of some, if not 
     most, of the nation's largest banks would themselves, in 
     private conversation, acknowledge the folly of Basel II. Many 
     former regulators have expressed serious reservations about, 
     if not outright opposition to, Basel II, including Jerry 
     Hawke, Bill Isaac, Bill Seidman, and others. Powell is 
     apparently sufficiently concerned that he has reignited the 
     debate over the FDIC's authority to examine banks already 
     being examined by other federal regulators.
       The fact that the chairmen and ranking members of both the 
     House Financial Services Committee and its financial 
     institutions subcommittee introduced legislation Thursday 
     that could slow down or even prevent adoption of Basel II 
     should also send a strong signal to the regulators.
       Fifth, I am not even convinced that the Federal Reserve 
     itself fully embraces Basel II, or even adequately 
     understands many of its implications. Some prominent members 
     of the Federal Reserve may still mistakenly believe that 
     regulatory capital does not affect competition or the pricing 
     and strategic decisions that banks make. This misconception 
     could help explain their preference for

[[Page 5682]]

     theoretical models rather than practical realities.
       Chairman Greenspan has been largely silent in the Basel II 
     debate, although the irony is that he prudently questions the 
     sufficiency of the capital levels at Fannie Mae and Freddie 
     Mac. But Basel II would actually allow banks to hold less 
     capital for the same mortgage assets than Fannie Mae and 
     Freddie Mac are required to hold.
       Current estimates of the capital that Basel II banks would 
     have to hold for mortgage assets would also be at or below 
     the capital level that led to the savings and loan crisis.
       Some at the Federal Reserve appear to be more attuned to 
     the importance of maintaining adequate regulatory capital 
     reserves. Timothy Geithner, the president and CEO of the 
     Federal Reserve Bank of New York, remarked recently that it 
     was important for the nation's largest financial institutions 
     to ``maintain an ample capital cushion over and above the 
     high regulatory thresholds.''
       He added that ``because of the broader implications of a 
     failure for the financial system and for the economy as a 
     whole, the supervisory framework for the largest 
     systematically significant banking organizations . . . needs 
     to produce a higher level of financial soundness than might 
     be indicated by measures of economic capital or expected by 
     shareholders and creditors of the institution.''
       Sixth, proponents like to argue that Basel II is necessary 
     to create competitive equity among internationally active 
     banks. No capital accord will ever accomplish that objective, 
     both because of significant differences in accounting 
     standards and the wide disparity in the quality of regulation 
     abroad, as Jerry Hawke has stated.
       Global regulatory consistency will never be achieved, 
     particularly when foreign banks abroad are examined only 
     sporadically and without anywhere near the same thoroughness 
     as U.S. banks. The reality is that U.S. banks have proven 
     stronger, more profitable, and more resilient than their 
     foreign counterparts in recent economic cycles.
       Seventh, there clearly is an effort afoot, pending Basel 
     II's adoption, to abolish the leverage ratio as inconsistent 
     with the principles of Basel II. Congress and U.S. regulators 
     must not weaken our country's important regulatory 
     protections such as the leverage ratio and prompt corrective 
     action regulations to emulate the questionable supervisory 
     oversight abroad.
       Although some at the Federal Reserve have provided 
     assurances that the leverage ratio will be maintained under 
     Basel II, some have left that question open. And powerful 
     institutional and lobbying forces have already voiced their 
     preference for capital regulations based exclusively on risk 
     based credit models, and have called for the elimination of 
     the leverage ratio.
       This cannot be allowed. Among other things, the leverage 
     ratio ensures that regardless of the risk-based models used 
     by banks, there is at least a base level of protection in the 
     event of a crisis, rather than relying primarily on an 
     insurance fund or taxpayer bailout.
       In sum, decades as a legislator have convinced me that the 
     most effective regulations are those that are easy to 
     understand, can be applied objectively and consistently, are 
     not subject to manipulation, and can be monitored effectively 
     by supervisors, managements, and market participants. This is 
     particularly the case when dealing with issues affecting the 
     stability of our domestic and global financial systems.
       With some reasonable updating, the existing Basel I 
     approach can continue to meet these goals and ensure that 
     sufficient capital is available as a cushion against mistakes 
     or unanticipated crises. Basel II would take us in a 
     dangerous direction toward subjective self-assessments of 
     capital and a dependence on complex theoretical models that 
     are subject to manipulation and incapable of being 
     effectively monitored.
       I see no consideration of safety and soundness at all in 
     the Basel II debate, and no recognition of the danger of 
     adopting a new capital regulation that goes in the exact 
     opposite direction from the recent reforms concerning 
     corporate governance, regulatory oversight, and internal 
     controls.

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