Testimony of Vice Chairman Roger W. Ferguson, Jr.
Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate
June 18, 2003
Chairman Shelby, Senator Sarbanes, members of the Committee, it is a pleasure to appear before you this morning on behalf of the Board of Governors to discuss Basel II, the evolving new capital accord for internationally active banking organizations. After five years of discussion, the proposal is entering its final stage of public comment and review, although there still remain additional steps to the process.
Why Is a New Capital Standard Necessary?
Shortcomings in Basel I
Basel I is too simplistic to address the activities of our most complex banking institutions. The framework has only four risk categories, and most loans receive the same regulatory capital charge even though loans made by banks encompass the whole spectrum of credit quality. The limited differentiation among the degrees of risk means that the calculated capital ratios are too often uninformative and might well provide misleading information for banks with risky or problem credits or, for that matter, with portfolios dominated by very safe loans.
Moreover, the limited number of risk categories creates incentives for banks to game the system through capital arbitrage. Capital arbitrage is the avoidance of certain minimum capital charges through the sale or securitization of bank assets for which the capital requirement that the market would impose is less than the current regulatory capital charge. For example, credit card loans and residential mortgages are securitized in volume, rather than held on banks' balance sheets, because the market requires less capital, in the form of bank credit enhancements, than Basel I requires in capital charges. This behavior by banks is perfectly understandable, even desirable in terms of economic efficiency. But it means that banks that engage in such arbitrage retain the higher-risk assets for which the regulatory capital charge--calibrated to assets of average quality--is on average too low.
To be sure, through the examination process supervisors are still able to evaluate the true risk position of the bank, but the regulatory minimum capital ratios of the larger banks are becoming less and less meaningful, a trend that will only accelerate. Not only are creditors, counterparties, and investors less able to evaluate the capital strength of individual banks from what are supposed to be risk-based capital ratios, but regulations and statutory requirements tied to capital ratios have less meaning as well. Basel I capital ratios neither adequately reflect risk nor measure bank strength at the larger banks.
The Evolving State of the Art
Increased Heterogeneity and Concentration in Banking
Second, the Basel II reform has several objectives: U.S. supervisors are trying to improve risk measurement and management both domestically and internationally; to link to the extent that we can the amount of required capital to the amount of risk taken; to further focus the supervisor-bank dialogue on the measurement and management of risk and the risk-capital nexus; and to make all of this transparent to the counterparties that ultimately fund--and hence share--these risk positions.
To achieve all these objectives, the framework for Basel II contains three elements, called Pillars 1, 2, and 3. The most important pillar, Pillar 1, consists of minimum capital requirements--that is, the rules by which a bank calculates its capital ratio and by which its supervisor assesses whether it is in compliance with the minimum capital threshold. As under Basel I, a bank's risk-based capital ratio under Basel II would have a numerator representing the capital available to the bank and a denominator that would be a measure of the risks faced by the bank, referred to as "risk-weighted assets". The definition of regulatory capital in the form of equity, reserves, and subordinated debt and the minimum required ratio, eight percent, are not changing. What would be different is the definition of risk-weighted assets, that is, the methods used to measure the "riskiness" of the loans and investments held by the bank. It is this modified definition of risk-weighted assets, its greater risk-sensitivity, that is the hallmark of Basel II. The modified definition of risk-weighted assets would also include an explicit, rather than implicit, treatment of "operational risk."
Pillar 2 addresses supervisory oversight; it encompasses the concept that well-managed banks should seek to go beyond simple compliance with minimum capital requirements and perform for themselves a comprehensive assessment of whether they have sufficient capital to support their risks. In addition, on the basis of their knowledge of industry practices at a range of institutions, supervisors should provide constructive feedback to bank management on these internal assessments.
Finally, Pillar 3 seeks to complement these activities with stronger market discipline by requiring banks publicly to disclose key measures related to their risk and capital positions. The concept of these three mutually reinforcing pillars has been central to the Basel II effort.
Scope of Application in the United States
Banks Remaining Under Current Capital Rules
Moreover, U.S. banks have long been subject to comprehensive and thorough supervision that is much less common in most other countries planning to implement Basel II. Indeed, U.S. supervisors will continue to be interested in reviewing and understanding the risk-measurement and management processes of all banks. Our banks also disclose considerable information through regulatory reports and under accounting rules and requirements of the Securities and Exchange Commission; they already provide significant disclosure--consistent with Pillar 3 of Basel II.
Thus, when we balanced the costs of imposing a new capital regime on thousands of our banks against the benefits--slightly more risk sensitivity of capital requirements under, say, the standardized version of Basel II for credit risk, and somewhat more disclosure--it did not seem worthwhile to require most of our banks to take that step. Countries with an institutional structure different from ours might clearly find universal application of Basel II to benefit their banking system, but we do not think that imposing Basel II on most of our banks is either necessary or practical.
Banks Moving to Basel II
Another important objective has been to encourage the largest banking organizations of the world to continue to incorporate into their operations the most sophisticated techniques for the measurement and management of risk. As I have noted, these entities use financial instruments and procedures that are not adequately captured by the Basel I paradigm. They have already begun to use--or have the capability to adopt--the techniques of modern finance to measure and manage their exposures; and because substantial difficulty at one of the largest banking organizations could have significant effects on global financial markets, all of the largest banks should be using these procedures. In our view, prudential supervisors and central bankers would be remiss if we did not address the evolving complexity of our largest banks and ensure that modern techniques were being used to manage their risks. The U.S. supervisors have concluded that the advanced versions of Basel II--the Advanced Internal Ratings Based (A-IRB) approach for measuring credit risk and the Advanced Measurement Approaches (AMA) for measuring operational risk--are best suited to achieve this last objective.
Under the A-IRB approach, a banking organization would have to estimate, for each credit exposure, the probability that the borrower will default, the likely size of the loss that will be incurred in the event of default: and--where the lender has an undrawn line of credit or loan commitment to the borrower--an estimate of what the amount borrowed is likely to be at the time a default occurs. These three key inputs--probability of default (PD), loss given default (LGD), and exposure at default (EAD)--are inputs that would be used in formulas provided by supervisors to determine the minimum required capital for a given portfolio of exposure. While the organization would estimate these key inputs, the estimates would have to be rigorously based on empirical information, using procedures and controls validated by its supervisor, and the results would have to accurately measure risk.
Those banks that are required, or choose, to adopt the A-IRB approach to measuring credit risk, would also be required to hold capital for operational risk, using a procedure known as the Advanced Management Approach (AMA) to establish the size of that charge. Under the AMA, banks themselves would bear the primary responsibility for developing their own methodology for assessing their own operational risk capital requirement. To be sure, supervisors would require that the procedures used are comprehensive, systematic, and consistent with certain broad outlines, and must review and validate each bank's process. In this way, a bank's "op risk" capital charge would reflect its own environment and controls. Importantly, the size of the charge could be reduced by actions that the bank takes to mitigate operational risk. This provides an important incentive for the bank to take actions to limit their potential losses from operational problems.
Determining Basel II Banks
Ten U.S. banks meet the proposed criteria to be core banks and thus would be required, under our proposal, to adopt A-IRB and AMA to measure their credit and operational risks, respectively. As they grow, other banks could very well meet the criteria and thus shift into the core group in the years ahead. We would also permit any bank that meets the infrastructure requirements of A-IRB and AMA--the ability to quantify and develop the necessary risk parameters on credit exposures and develop measurement systems for operational risk exposures--to choose Basel II. Banks that choose to use A-IRB and AMA would need to consider several factors, including the benefits of Basel II relative to its costs, the nature of their operations, the capital impact, and the message they want to send their counterparties about their risk-management techniques. We anticipate that after conducting such a review, about ten or so large banks now outside the core group would choose to adopt Basel II in the near term. Thus we expect about twenty banks to adopt the advanced version of Basel II before or shortly after the initial implementation date.
Over time, other large banks, perhaps responding to market pressure and facing declining costs and wider understanding of the technology, may also choose this capital regime, but we do not think that the cost-benefit assessment would induce smaller banks to do so for a very long time. Our discussions with the rating agencies confirm they do not expect that regional banks would find adoption of Basel II to be cost effective in the initial implementation period. Preliminary surveys of the views of bank equity security analysts indicate that they are more focused on the disclosure aspects of Basel II rather than on the scope of application. To be clear, supervisors have no intention of pressuring any of the banks outside the core group to adopt Basel II.
The ten core banks that would be required to adopt Basel II, together with the approximately ten self-selecting banks that we anticipate would adopt it before or shortly after the initial implementation date, today account for 99 percent of the foreign assets and two-thirds of all the assets of domestic U.S. banking organizations, a rate of coverage demonstrating the importance of these entities to the U.S. and global banking and financial markets. These data also underscore our commitment to international competitive equity and the adoption of best-practice policies at the organizations critical to our financial stability while minimizing cost and disruption at our purely domestic, less-complicated organizations.
This ratio is further enhanced because attributing to Basel II all the costs associated with the adoption of modern, formal risk-management systems is a logical fallacy. The large banks that would be required, or that would choose, to adopt A-IRB and AMA must compete for funding in a global marketplace and thus already have adopted many of these processes and would continue to develop them even without Basel II. The new accord may well appropriately speed up the adoption process, but overall, the costs of adopting these processes are being forced on these banks not by Basel II but by the requirements of doing business in an increasingly complex financial environment. In any event, the ANPR will include questions designed to quantify the cost of implementing Basel II.
Another issue relates to the concern among U. S. Basel II banks of the potential competitive edge that might be given to any bank that would have its capital requirements lowered by more than that of another Basel II bank. The essence of Basel II is that it is designed to link the capital requirement to the risk of the exposures of each individual bank. A bank that holds mainly lower-risk assets, such as high-quality residential mortgages, would have no advantage over a rival that held mainly lower-quality, and therefore riskier, commercial loans just because the former had lower required capital charges. The capital requirements should be a function of risk taken, and, under Basel II, if the two banks had very similar loans, they both should have a very similar required capital charge. For this reason, competitive equity among Basel II banks in this country should not be a genuine issue because capital should reflect risk taken. Under the current capital regime, banks with different risk profiles have the same capital requirements, creating now a competitive inequity for the banks that have chosen lower risk profiles.
The most frequently voiced concern about possible competitive imbalance reflects the "bifurcated" rules implicit in the U.S. supervisors' proposed scope of application: that is, requiring Basel II through A-IRB and AMA for a small number of large banks while requiring the current capital rules for all other U.S. banks. The stated concern of some observers is that the banks that remained under the current capital rules, with capital charges that are not as risk sensitive, would be at a competitive disadvantage compared to Basel II banks that would get lower capital charges on less-risky assets. The same credit exposure might have a lower regulatory minimum capital charge at a Basel II bank than at a Basel I bank. Of course, Basel II banks would have higher capital charges on higher-risk assets and the cost of adopting a new infrastructure, neither of which Basel I banks would have. And any bank that might feel threatened could adopt Basel II if they would make the investment required to reach the qualifying criteria.
But a concern remains about competitive equity in our proposed scope of application, one that could present some difficult trade-offs if the competitive issue is real and significant. On the one hand is the pressing need to reform the capital system for the largest banks and the practical arguments for retaining the present system for most U.S. banks. Against that is the concern that there might be an unintended consequence of disadvantaging those banks that would remain on the current capital regime.
We take the latter concern seriously and will be exploring it through the ANPR. But, without prejudging the issue, there are reasons to believe that little if any competitive disadvantage would be brought to those banks remaining under the current capital regime.
The basic question is the role of minimum regulatory capital requirements in the determination of the price and availability of credit. Economic analysis suggests that regulatory capital should be considerably less important than the capital allocations that banks make internally within their organization, so-called economic capital. Our understanding of bank pricing is that it starts with economic capital and the explicit recognition of the riskiness of the credit and is then adjusted on the basis of market conditions and local competition from bank and nonbank sources. In some markets, some banks will be relatively passive price takers. In either case, regulatory capital is mostly irrelevant in the pricing decision, and therefore unlikely to cause competitive disparities.
Moreover, most banks, and especially the smaller ones, hold capital far in excess of regulatory minimums for various reasons. Thus, changes in their own or their rivals' minimum regulatory capital generally would not have much effect on the level of capital they choose to hold and would therefore not necessarily affect internal capital allocations for pricing purposes.
In addition, the banks that most frequently express a fear of being disadvantaged by a bifurcated regulatory regime have for years faced capital arbitrage from larger rivals who were able to reduce their capital charges by securitizing loans for which the regulatory charge was too high relative to the market or economic capital charge. The more risk-sensitive A-IRB in fact would reduce the regulatory capital charge in just those areas where capital requirements are too high under the current regime. In those areas, capital arbitrage has already reduced the regulatory capital charge. The A-IRB would provide, in effect, risk-sensitive capital charges for lower-risk assets that are similar to what the larger banks have for years already obtained through capital arbitrage. In short, competitive realities between banks might not change in many markets in which minimum regulatory capital charges would become more explicitly risk sensitive.
Concerns have also been raised about the effect of Basel II capital requirements on the competitive relationships between depository institutions and their nondepository rivals. Of course, the argument that economic capital is the driving force in pricing applies in this case, too. Its role is only reinforced by the fact that the cost of capital and funding is less at insured depositories than at their nondepository rivals because of the safety net. Insured deposits and access to the Federal Reserve discount window (and Federal Home Loan Bank advances) let insured depositories operate with far less capital or collateralization than the market would otherwise require of them and far less than it does require of nondepository rivals. Again, Basel II would not change those market realities.
Let me repeat that I do not mean to dismiss competitive equity concerns. Indeed, I hope that the comments on the ANPR bring forth insights and analyses that respond directly to the issues, particularly the observations I have just made. But, I must say, we need to see reasoned analysis and not assertions.
Operational disruptions have caused banks to suffer huge losses and, in some cases, failure here and abroad. At times they have dominated the business news and even the front pages. Appendix 1 to this statement lists the ten largest such events of recent years. In an increasingly technology-driven banking system, operational risks have become an even larger share of total risk; at some banks they are the dominant risk. To avoid addressing them would be imprudent and would leave a considerable gap in our regulatory system.
A capital charge to cover operational risk would no more eliminate operational risk than a capital charge for credit risk eliminates credit risk. For both risks, capital is a measure of a bank's ability to absorb losses and survive without endangering the banking and financial system. The AMA for determining capital charges on operational risk is a principles-based approach that would obligate banks to evaluate their own operational risks in a structured but flexible way. Importantly, a bank could reduce its operational-risk charge by adopting procedures, systems, and controls that reduce its risk or by shifting the risk to others through measures such as insurance. This approach parallels that for credit risk, in which capital charges can be reduced by shifting to less-risky exposures or by making use of risk-mitigation techniques such as collateral or guarantees.
Some banks for which operational risk is the dominant risk oppose an explicit capital charge on operational risk. Some of these organizations tend to have little credit exposure and hence very small required capital under the current regime, but would have significant required capital charges should operational risk be explicitly treated under Pillar 1 of Basel II. Such banks, and also some whose principal risks are credit-related, would prefer that operational risk be handled case by case through the supervisory review of buffer capital under Pillar 2 of the Basel proposal rather than be subject to an explicit regulatory capital charge under Pillar 1. The Federal Reserve believes that would be a mistake because it would greatly reduce the transparency of risk and capital that is such an important part of Basel II and would make it very difficult to treat risks comparably across banks because Pillar 2 is judgmentally based.
Most of the banks to which Basel II would apply in the United States are well along in developing their AMA-based capital charge and believe that the process has already induced them to adopt risk-reducing innovations. Presentations at a conference held late last month illustrated the significant advances in operational-risk quantification being made by most internationally active banks. The presentations were made by representatives from most of the major banks in Europe, Asia, and North America, and many presenters enthusiastically supported the use of AMA-type techniques to incorporate operational risk in their formal modeling of economic capital. Many banks also acknowledged the important role played by the Basel process in encouraging them to develop improved operational risk management.1
Overall Capital and An Evolving Basel II
Of course, capital ratios are not the sole consideration. The improved risk measurement and management, and its integration into the supervisory system, under Basel II, are also critical to ensuring the safety and soundness of the banking system. When coupled with the special U.S. features, such as prompt corrective action, minimum leverage ratios, statutory provisions that make capital a prerequisite to exercising additional powers, and market demands for buffer capital, some modest reduction in the minimum regulatory capital for sound, well managed banks could be tolerable. And, I note that banks with lower risk profiles, as a matter of sound public policy, should have lower capital than banks with higher risk profiles. Greater dispersion in required capital ratios, if reflective of underlying risk, is an objective, not a problem to be overcome.
I should also underline that Basel II is designed to adapt to changing technology and procedures. I fully expect that in the years ahead banks and supervisors will develop better ways of estimating risk parameters as well as better functions that convert those parameters to capital requirements. When they do, these changes could be substituted directly into the Basel II framework, portfolio by portfolio if necessary. Basel II would not lock risk management into any particular structure; rather Basel II could evolve as best practice evolves and, as it were, be evergreen.
The Schedule and Transparency
When the comments on CP3 and the ANPR have been received, the agencies will review them and meet to discuss whether changes are required in the Basel II proposal. In November, we are scheduled to meet in Basel to negotiate our remaining differences. I fear this part of the schedule may be too tight because it may not provide U.S. negotiators with sufficient time to digest the comments on the ANPR and develop a national position to present to our negotiating partners. There may well be some slippage from the November target, but this slippage in the schedule is unlikely to be very great.
In any event, implementation in this country of the final agreement on Basel II would require a Notice of Proposed Rulemaking (NPR) in 2004 and a review of comments followed by a final rule before the end of 2004. On a parallel track, core banks and potential opt-in banks in the United States will be having preliminary discussions with their relevant supervisors in 2003 and 2004 to develop a work plan and schedule. As I noted, we intend to conduct more Quantitative Impact Studies, starting in 2004, so we can be more certain of the impact of the proposed changes on individual banks and the banking system. As it stands now, core and opt-in banks will be asked by the fall of 2004 to develop an action plan leading up to final implementation. Implementation by the end of 2006 would be desirable, but each bank's plan will be based on a joint assessment by the individual bank and its relevant supervisors of a realistic schedule; for some banks the adoption date may be beyond the end of 2006 because of the complexity of the required changes in systems. It is our preference to have an institution "do it right" rather than "do it quickly". We do not plan to force any bank into a regime for which it is not ready, but supervisors do expect a formal plan and a reasonable implementation date. At any time during that period, we can slow down the schedule or revise the rules if there is a good reason to do so.
The development of Basel II has been highly transparent from the beginning and will remain so. All of the consultative papers over the past five years have been supported by a large number of public papers and documents to provide background on the concepts, framework, and options. After each previous consultative paper, extensive public comment has been followed by significant refinement and improvement of the proposal.
During the past five years, a number of meetings with bankers have been held in Basel and in other nations, including the United States. Over the past eighteen months, I have chaired a series of meetings with bankers, often jointly with Comptroller Hawke. More than 20 U.S. banks late last year joined 365 others around the world in the third Quantitative Impact Survey (QIS3), which was intended to estimate the effects of Basel II on their operations. The banking agencies last month held three regional meetings with the bankers that would not be required to adopt Basel II but might have an interest in choosing to adopt the A-IRB approach and the AMA. Our purpose was to ensure that these banks understand the proposal and the options it provides them.2 As I noted, in about one month the banking agencies in this country hope to release an ANPR that will outline and seek comment on specific proposals for the application of Basel II in this country. In the past week or so we have also released two White Papers to help commenters frame their views on commercial real estate and the capital implications of recognizing certain guarantees. These, too, are available at our web site.
This dialogue with bankers has had a substantive impact on the Basel II proposal. I have attached to my statement a comparison of some of the major provisions of Basel II as proposed in each of the three consultative documents published by the Basel Committee on Bank Supervision (appendix 2). As you can see, commenters have significantly influenced the shape and detail of the proposal. For example, comments about the earlier proposed crude formulas for addressing operational risk led to a change in the way capital for operational risk may be calculated; banks' may now use their own methods for assessing this form of risk, as long as these methods are sufficiently comprehensive and systematic and meet a set of principles-based qualifying criteria. That is the AMA. The mechanism for establishing capital for credit risk has also evolved significantly since the first consultative paper on the basis of industry comments and suggestions; as a result, a large number of exposure types are now treated separately. Similarly, disclosure rules have been simplified and streamlined in response to industry concerns.
At this stage of the proposal, comments that are based on evidence and analysis are most likely to be effective. Perhaps an example of the importance of supporting evidence in causing a change in positions might be useful. As some members of this committee may know, the Federal Reserve had concluded earlier, on the basis of both supervisory judgment and the available evidence, that the risk associated with commercial real estate loans on certain existing or completed property required a capital charge higher than the capital charge on other commercial real estate and on commercial and industrial loans. In recent weeks, however, our analysis of additional data suggested that the evidence was contradictory. With such inconsistent empirical evidence, we concluded that, despite our supervisory judgment on the potential risk of these exposures, we could not support requiring a higher minimum capital charge on commercial real estate loans on any existing or completed property, and we will not do so.
In the same vein, we also remain open minded about proposals that simplify the proposal but attain its objective. Both the modifications of the proposals in CP3 and the changes in U.S. supervisory views, as evidenced by the commercial real estate proposal, testify to the willingness of the agencies, even at this late stage of the process, to entertain new ideas and to change previous views when warranted.
The Basel II framework is the product of extensive multiyear dialogues with the banking industry regarding evolving best practice risk-management techniques in every significant area of banking activity. Accordingly, by aligning supervision and regulation with these techniques, it provides a great step forward in protecting our financial system and that of other nations to the benefit of our citizens. Basel II will provide strong incentives for banks to continue improving their internal risk-management capabilities as well as the tools for supervisors to focus on emerging problems and issues more rapidly than ever before.
I am pleased to appear before you today to report on this effort as it nears completion. Open discussion of complex issues has been at the heart of the Basel II development process from the outset and will continue to characterize it as Basel II evolves further.
Appendix 1 (14 KB PDF): Large Losses from Operational Risk, 1992-2002 Return to text
Appendix 2 (40 KB PDF): Evolution of Basel II Proposals Return to text
1. Papers from that conference are available at http://www.newyorkfed.org/pihome/news/speeches/2003/con052903.html Return to text
2. The documents used in these presentations are available at the Board's web site, http://www.federalreserve.gov/banknreg.htm ("Documents Relating to US Implementation of Basel II"). Return to textReturn to top