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

Remarks by Senior Associate Director Roger T. Cole
At the Federal Reserve Board of Governors, Washington, D.C.
March 30, 2006

Thank you, Governor Bies.

The capital proposal for consideration today will provide the industry and others with detailed information on the U.S. implementation of Basel II so that they can plan accordingly and we can continue to benefit from their comments in developing a more risk-sensitive capital framework. The OCC and OTS are required by Executive Order 12866 to submit the NPR to OMB for review. This review process could take as long as 90 days. Board staff is prepared to work with the other agencies to address any issues raised by OMB in the coming weeks. At this point staff believes that there is considerable merit for the Board to consider the NPR at this time.

Not included in the draft proposal for consideration today is a trading book proposal that will subsequently be presented to the Board and, if approved by the Board and the other agencies, would be issued in the Federal Register at the same time as the proposal under consideration today. In addition, agency staffs are working on a package of supervisory reporting templates that, if approved by the Board and the other agencies, would be issued for public comment at the same time as the NPR. Shortly after issuing these proposals for comment, staff expects to seek the Board's approval to issue for public comment Basel II-related interagency supervisory guidance. Further, staff intends to ask the Board to approve issuance of an interagency NPR on possible Basel I modifications in time to provide meaningful overlap in the comment periods for both the Basel I and Basel II NPRs, thereby providing the basis for commenting on a comprehensive package of proposed changes to U.S. regulatory capital requirements.

The documents that relate to the Basel II capital framework are both long and complex, reflecting the innovative and sophisticated products and services of large, internationally active banks. Throughout these documents, questions are posed to commenters with the expectation that their answers will provide further factual and analytical bases for interagency development of a final rule. Accordingly, commenters are encouraged to address both the specific questions raised in the NPR and to comment on all aspects of these proposals.

The Basel II framework contains three pillars. In Pillar I, regulatory capital requirements, the framework seeks to achieve a balance between risk sensitivity and prudence by building on certain bank-specific inputs but deriving credit risk capital requirement outputs from formulas prescribed by regulators. Pillar 2 draws upon existing U.S. supervisory practice and requires supervisory review of the bank's own internal capital assessment process to determine the bank's total capital needs, including addressing risks not captured in Pillar 1, such as interest rate risk and credit risk concentrations. Pillar 3 also draws from existing U.S. practice by requiring appropriate public disclosure of bank-specific financial information to enhance transparency and market discipline. Together, the three pillars should move banks further toward leading risk-measurement and management practices. In addition, both supervisors and the market should be better able to assess how capital and risks evolve over time, and which institutions are outliers from a capital adequacy perspective.

It is clear from the interagency discussion that each agency is fully committed to maintaining the safety and soundness of the U.S. banking system. In short, no banking agency wants capital at any banking organization to fall below a safe and sound level. This deep-seated concern has prompted the agencies to propose both procedural and substantive safeguards as the Basel II framework is implemented in the United States over the coming years. The process safeguards include continual in-depth review and analysis of Basel II implementation starting with the parallel run in 2008 as well as use of supervisory review and approval processes before any bank would be permitted to use the Basel II risk-based capital rules. The quantitative safeguards include a series of floors during a three-year transition period and the use of a credit risk multiplier (proposed as 1.06).

To assist in the evaluation of both the quantitative impact of Basel II on banks' risk-based capital requirements and the quality of banks' systems for estimating Basel II risk parameters, the agencies have conducted a series of quantitative impact studies (QIS). The most recent QIS exercise, QIS 4, was conducted on a best-efforts basis without close supervisory oversight and reflects only a point-in-time look at bank portfolios and risk-measurement and management systems. An important finding of QIS 4 was that banks' systems for estimating Basel II risk parameters were only partially developed at the time of the exercise in the fall of 2004 and would not have met supervisory expectations at that time. Since then, much progress has been made on systems development by many of these institutions.

The QIS 4 findings and other considerations have resulted in the agencies proposing a one-year delay in implementation and a lengthening of the transition period from two to three years. Uncertainty surrounding the precise quantitative impact of Basel II has been incorporated into the agencies' implementation plan for the United States. An essential element of that plan is the release of the current proposal and related supervisory guidance for public comment. This will provide time for banks that expect to adopt Basel II risk-based capital requirements to refine their internal systems. It will also provide time for supervisors to prepare for their own implementation requirements. More precise estimates of the quantitative impact of Basel II should become available during the "parallel run" period (beginning January 2008) and transition periods (beginning in January 2009). The agencies intend to use analysis of information gathered during these periods to determine whether any modifications to the Basel II framework or its U.S. implementation are needed--for example, to preclude an unwarranted decline in bank risk-based capital requirements.

The regulators are proposing, subsequent to the parallel run period, a three-year phase-in of Basel II as a safeguard to ensure that no bank would be permitted to operate under Basel II until it has proved ready to do so. Accordingly, a bank will be able to move from the parallel run to live Basel II capital calculations with a 95 percent floor only after it has received approval to do so from its primary supervisor, based on a thorough evaluation of its risk management methodologies and its ability to calculate risk-based capital requirements using the Basel II framework. A similar approach would be taken for the 90 percent and 85 percent floors applicable in the second and third transition years. After the third year of floors, a bank would only be able to move to the full Basel II risk-based capital calculation without floors upon a finding by the primary supervisor that the bank's systems appropriately reflect risk exposures and produce prudent risk-based capital requirements.

During the parallel run as well as during the transition years, agency staffs will, on an ongoing basis, evaluate the implementation, results and effectiveness of the framework. These assessments will include an analysis of how well the framework measures risk exposure and how effectively the resulting capital requirements support that exposure. The NPR preamble notes that if there is a material reduction in minimum regulatory capital requirements upon implementation of Basel II, the agencies will propose regulatory changes or adjustments during the transition period. The preamble recognizes that materiality will depend on a number of factors relevant to the maintenance of a safe and sound banking system. In addition, the preamble identifies a 10 percent or greater decline in aggregate minimum risk-based capital as a benchmark for evaluating and responding to capital outcomes.

Even beyond the transition safeguards, the proposal indicates that other prudential supervisory provisions will remain in effect. For example, the current leverage ratio requirement--a ratio of capital to total average assets--will remain unchanged for all banking organizations, whether or not they are subject to the Basel II framework. Also, supervisors will continue to vigorously enforce existing law requiring supervisors and banks to take prompt corrective action in response to declines in capital. As the consolidated supervisor for financial holding companies (FHCs), the Federal Reserve will also continue to apply the requirements in existing law, regulations and supervisory guidance that banks be "well capitalized" and "well managed."

A few words should be said about the Guidance documents that are being developed jointly by staffs of the U.S. banking agencies. It has been traditional policy for the agencies to develop Guidance documents for field supervisors in order to foster consistency. Such Guidance traditionally has been shared with bank management so that they can better understand what will be expected of them. Like the NPR, staff believes that these draft Guidance documents should be released to the public for two reasons: to seek public comment on the substance of the Guidance and to help bank management better understand what the supervisors will expect of banks that adopt the Advanced Internal Ratings-Based Approach for credit risk and the Advanced Measurement Approaches for operational risk under Basel II.

The vast majority of U.S. banks can safely continue to operate under Basel I as it will be amended through the rulemaking process. Changes to the Basel I framework have been made more than twenty-five times since it was first introduced in response to changes in the banking system and a better understanding of the risks associated with individual products and services. Concerns have been raised about potential competitive inequities between Basel II banks and Basel I banks. As noted earlier, to mitigate these concerns, agency staffs are discussing ways to enhance the risk sensitivity of the U.S. Basel I rules. Currently, agency staffs are reviewing comments received on the ANPR and considering alternatives that might be further developed. A critical element of these discussions is balancing the desire to enhance risk sensitivity and mitigate potential competitive disparities without imposing undue regulatory burden.

Another area where questions have been raised relates to the ability of the banking agencies to adequately staff the implementation of the new Basel II framework. The Board and Federal Reserve Banks have been hiring and training supervisory staff in risk management, economic capital, and specific aspects of Basel II for some time. This will, if anything, continue to be an area of high priority and emphasis. We note that in addition to preparing for Basel II, our supervisory hiring and training processes focus on maintaining and enhancing skills needed to assess risk and risk management developments at our largest institutions on a continuing basis.

Lastly, I would like to note that recently passed legislation (the Federal Deposit Insurance Reform Conforming Amendments Act of 2005), directs the GAO to conduct a study looking at the potential impact of Basel II implementation on the U.S. financial system. Agency staffs will consider issues identified in the study going forward.

Mr. Chairman, Board staff recommends that the Board approve issuance for public comment of the draft NPR implementing a new risk-based capital adequacy framework. Staff also would like the Board's approval to make modest, non-substantive changes in the NPR before its publication in the Federal Register. Any more substantive changes would be submitted to the Board for additional consideration.

My colleagues and I now welcome questions or comments from the Board.