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Basel II Capital Accord
Notice of Proposed Rulemaking (NPR) and Supporting Board Documents

Remarks by Governor Susan Schmidt Bies
At the Federal Reserve Board of Governors, Washington, D.C.
March 30, 2006

Thank you, Mr. Chairman.

First of all, I would like to say that I am pleased that the Board of Governors has the opportunity today to initiate our approval process of the interagency notice of proposed rulemaking (NPR) that would be the next step to implement Basel II in the United States. The draft of the NPR that is available for our public meeting today has already been sent to the Office of Management and Budget by the Office of the Comptroller of the Currency and the Office of Thrift Supervision to move forward their approval processes. The NPR is expected to be issued in the Federal Register after all of the U.S. banking agencies complete their review and approval processes, at which time it will be officially out for comment.

I want to take a moment to thank the staffs at each of the banking agencies for their considerable efforts in developing the NPR--a complicated and highly technical undertaking. I particularly want to thank the staff at the Federal Reserve for working so effectively together, including various divisions at the Board and many supervisors in the Reserve Banks.

While it has taken substantial time and considerable effort to reach this point, I believe the proposal will give the industry, the Congress, and other interested parties a better understanding of the agencies' implementation plans. I look forward to feedback in response to the proposal, particularly comments that will help us assess the overall direction we have outlined and comments that focus on the details of the proposal. In some areas of the proposal, the agencies are still considering various approaches and, thus, the text contains a number of questions asking for specific feedback. All of this will help us to develop the framework further.

I will not try to summarize the NPR here today. Rather, I would like to underscore the reasons why I believe it is important to move forward with the implementation of Basel II in the United States at this time.

The current Basel I capital framework, adopted nearly twenty years ago, was an innovation in its time, but it does not explicitly address many of the risks associated with the complex and sophisticated products, services, and operating systems that large, internationally active banks offer and use today. We need a better capital framework for these banking institutions and I believe that Basel II is such a framework.

One of the major ways in which Basel II should provide improvements is by linking capital requirements more closely to risk. The current Basel I capital requirements are not very risk sensitive and do not provide enough meaningful information about risk to bankers, supervisors, or the marketplace. For example, under Basel I it is possible for two banks with dramatically different risk profiles in their commercial loan portfolios to have the same regulatory capital requirement. Moreover, a bank's capital requirement may not reflect deterioration in asset quality. In addition, the general focus of Basel I on credit risk does not adequately capture risks of certain off-balance-sheet transactions and fee-based activity--for example, the operational risk embedded in many of the services from which large U.S. institutions generate a large and growing portion of their revenues.

In addition to enhancing the risk-sensitivity of regulatory capital, Basel II is designed to make the financial system safer by substantially improving risk management at the largest banks. Basel II builds on the existing risk-management practices of banks and is designed to move the industry toward best practice with regard to risk measurement and management. By providing a consistent framework for all banks to use, supervisors will more readily be able to identify portfolios and banks whose risk management and risk levels are significantly different from the range seen in other banks. By communicating these differences to banks, management will be able to benchmark their risk assessments, models, and processes in a more detailed and regular manner. We have already seen some progress in risk management at many institutions in the United States and around the globe as a result of discussions about and preparations for Basel II. The new framework is also more consistent than Basel I with the internal capital measures that institutions use to manage their business.

Basel II would also provide supervisors with a more conceptually consistent and more transparent framework for assessing the linkage of risk and capital over time at our most complex institutions, identifying which institutions have capital deficiencies, and, ultimately, evaluating systemic risk in the banking system through credit cycles. Therefore, Basel II establishes a more coherent relationship between how supervisors assess regulatory capital and how they supervise banks, enabling examiners to better evaluate whether banks have prudent capital levels and to better understand capital differences across institutions. As a complement to the more direct link between regulatory capital and measured risk, Basel II also requires banks to assess internally their overall capital needs and supervisors to evaluate how well banks are doing this. This type of supervisory oversight is well established in the U.S. supervisory community, and Basel II highlights the importance of this practice globally. Basel II also requires certain public disclosures. These disclosures improve transparency so that market participants can better assess a bank's risk profile and the adequacy of its level of capital.

As a central bank and a supervisor of banks and bank and financial holding companies, the Federal Reserve is committed to ensuring that the Basel II framework delivers a strong and risk-sensitive base of capital. That is why the proposal contains safeguards to ensure strong capital levels during and after the transition to Basel II, and why we will remain vigilant in monitoring Basel II's impact on an ongoing basis. This means that during and after the transition to Basel II, supervisors will rely upon ongoing, detailed analyses to continuously evaluate the results of the new Basel framework and ensure prudent levels of capital are being maintained by banks. Clearly, the Federal Reserve believes that strong capital is fundamentally important to the health of our banking system. Thus, we will continue our tradition of ensuring that U.S. banks maintain appropriate capital levels as a needed cushion against risk-taking.

The proposal indicates that the agencies will continue to use existing prudential measures to complement Basel II. For example, the current leverage ratio requirement--a ratio of capital to total assets--will remain unchanged for all banks, whether or not they are subject to the Basel II framework. Also, supervisors will continue to enforce existing law requiring prompt corrective action in response to declines in capital. Both the leverage ratio and prompt corrective action are fully consistent with Basel II.

Finally, I would like to echo Chairman Bernanke that the NPR is a proposed--not final--rulemaking. The proposals in the NPR could change based on comments received or on new information gathered by the U.S. agencies. Given the breadth and depth of these proposals, it is critical that we consider all viewpoints and make sure the framework operates as intended. If the U.S. agencies see that Basel II is not accurately reflecting risk or is producing unacceptable capital levels, we will seek to make changes. Indeed, we expect to make some adjustments as we move forward, just as changes have been made to the Basel I rules over the years to reflect changes in bank practice and improvements in supervision.

In sum, I consider today's release of the NPR text a very positive development in the process to revise regulatory capital requirements for large, internationally active U.S. banking institutions. I believe that the NPR meets the objectives laid out for undertaking Basel II in the first place. But it is now time for the U.S. banking agencies to listen to feedback from the industry, the Congress, and others, and then consider ways to further develop our proposals.