[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
THE NEW BASEL ACCORD: SOUND
REGULATION OR CRUSHING COMPLEXITY?
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
DOMESTIC AND INTERNATIONAL
MONETARY POLICY, TRADE AND TECHNOLOGY
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
FEBRUARY 27, 2003
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-5
86-852 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpr.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice JULIA CARSON, Indiana
Chairman BRAD SHERMAN, California
RON PAUL, Texas GREGORY W. MEEKS, New York
PAUL E. GILLMOR, Ohio BARBARA LEE, California
JIM RYUN, Kansas JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois CHARLES A. GONZALEZ, Texas
WALTER B. JONES, Jr., North MICHAEL E. CAPUANO, Massachusetts
Carolina HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
MARK GREEN, Wisconsin JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona MIKE ROSS, Arkansas
VITO FOSELLA, New York CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
MELISSA A. HART, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
TOM FEENEY, Florida DAVID SCOTT, Georgia
JEB HENSARLING, Texas ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey
TIM MURPHY, Pennsylvania BERNARD SANDERS, Vermont
GINNY BROWN-WAITE, Florida
J. GRESHAM Barrett, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Domestic and International
Monetary Policy, Trade and Technology
PETER T. KING, New York, Chairman
JUDY BIGGERT, Illinois, Vice Chair CAROLYN B. MALONEY, New York
JAMES A. LEACH, Iowa BERNARD SANDERS, Vermont
MICHAEL N. CASTLE, Delaware MELVIN L. WATT, North Carolina
RON PAUL, Texas MAXINE WATERS, California
DONALD A. MANZULLO, Illinois BARBARA LEE, California
DOUG OSE, California PAUL E. KANJORSKI, Pennsylvania
JOHN B. SHADEGG, Arizona BRAD SHERMAN, California
MARK R. KENNEDY, Minnesota DARLENE HOOLEY, Oregon
TOM FEENEY, Florida LUIS V. GUTIERREZ, Illinois
JEB HENSARLING, Texas NYDIA M. VELAZQUEZ, New York
TIM MURPHY, Pennsylvania JOE BACA, California
J. GRESHAM BARRETT, South Carolina RAHM EMANUEL, Illinois
KATHERINE HARRIS, Florida
C O N T E N T S
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Page
Hearing held on:
February 27, 2003............................................ 1
Appendix
February 27, 2003............................................ 53
WITNESSES
Thursday, February 27, 2003
Ervin, D. Wilson, Managing Director and Head of Strategic Risk
Management, Credit Suisse First Boston......................... 42
Ferguson, Roger W. Jr., Vice Chairman, Board of Governors of the
Federal Reserve System......................................... 9
Hawke, Hon. John D. Jr., Comptroller, Office of the Comptroller
of the Currency................................................ 11
Moore, Sarah, Chief Operating Officer, The Colonial Bank Group
Inc............................................................ 44
Petrou, Karen Shaw, Executive Director, Federal Financial
Analytics, Inc................................................. 37
Powell, Hon. Donald, Chairman, Federal Deposit Insurance
Corporation.................................................... 14
Spina, David, Chairman and Chief Executive Officer, State Street
Corporation.................................................... 40
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 54
Emanuel, Hon. Rahm........................................... 56
Ervin, D. Wilson............................................. 58
Ferguson, Roger W. Jr........................................ 74
Hawke, Hon. John D. Jr....................................... 94
Moore, Sarah................................................. 120
Petrou, Karen Shaw........................................... 133
Powell, Hon. Donald.......................................... 145
Spina, David................................................. 160
Additional Material Submitted for the Record
Maloney, Hon. Carolyn B.:
Letter to Hon. Alan Greenspan, Chairman, Federal Reserve
System Board of Governors, Hon. John D. Hawke, Comptroller
of the Currency, and Hon. Donald Powell, Chairman, Federal
Deposit Insurance Corporation, August 14, 2002............. 171
Letter from Hon. John D. Hawke, Jr., Comptroller, Office of
the Comptroller of the Currency, September 6, 2002......... 173
Bond Market Association letter, February 27, 2003 (with
attachments)................................................... 176
Real Estate Roundtable, prepared statement, March 11, 2003....... 208
THE NEW BASEL ACCORD: SOUND
REGULATION OR CRUSHING COMPLEXITY?
----------
Thursday, February 27, 2003
U.S. House of Representatives,
Subcommittee on Domestic and International
Monetary Policy, Trade and Technology
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 10:05 a.m., in
Room 2128, Rayburn House Office Building, Hon. Judy Biggert
[chairwoman of the subcommittee] presiding.
Present: Representatives Biggert, Kennedy, Feeney, Oxley,
Hensarling, Murphy, Barrett, Harris, Maloney, Lee, Sherman,
Frank, Baca, Emanuel, Capuano and Lynch.
Chairwoman Biggert. [Presiding.] This hearing of the
Subcommittee on Domestic and International Monetary Policy,
Trade and Technology will come to order. Without objection, all
members' opening statements will be made a part of the record.
We would like to welcome everybody here today. I will start
with my opening statement.
Good morning. I would like to thank the witnesses for
appearing this morning to outline the revisions of Basel
Capital Accord, currently under discussion at the Bank of
International Settlements. We have two very knowledgeable
panels of experts before the subcommittee today, and I look
forward to your testimony.
The Basel Accord plays such a critical role in the
operations of every bank that any changes to this accord must
be closely monitored by the regulators and the Congress. The
Federal Reserve and the other regulators have been hard at work
seeking improvements in the Basel I structure. I want to thank
you for all of your hard work on this complex issue. There is
no question that there are flaws in the current system and
change is needed. Many of the proposed changes to the Basel
Accord are sound and will go a long way to reducing risk in the
banking system and ensuring the efficiency of our national
banks.
I am, however, very concerned about the complexity of Basel
II and the ability to effectively implement it. If we are going
to go down the path of changing the primary tool used to
protect against excessive risk, then we must make sure that it
can be easily implemented and will not result in unforeseen
costs. According to the regulators, Basel II will only apply to
the largest U.S. financial institutions. However, many of us
are concerned that the market could, in effect, force all U.S.
institutions to comply with Basel II if they wish to remain
competitive. The bottom line is that institutions that do not
have the resources to turn the sophisticated models required by
Basel II could be forced to consolidate their operations or to
severely limit the types of products they offer.
One of my primary concerns is the operational risk capital
charge that will come under Pillar I of Basel II. This is a new
capital charge which will be included with charges for credit
risk and interest rate risk. Operational risk includes in its
calculus possible losses from employee misconduct, fraud,
system failure and litigation risk. These factors are very
difficult to quantify for large banks, and nearly impossible to
measure for smaller and medium-sized banks. So I question the
logic of imposing a burdensome capital charge on institutions
that is based mostly in theory, rather than on hard facts.
Some have asserted that operational risk is simply the
catch-all category of Basel II and has been included simply to
define risks that are already accounted for in the capital
accounts of most institutions. I would like to see if it would
make more sense to include these risks under a more flexible
Pillar II supervisory structure, instead of lumping them into a
mandatory capital charge.
I am also interested in the issue of home host regulators
and how Basel II will ensure that foreign regulators will hold
their financial institutions to the high standards that U.S.
institutions are held. As we saw with the Basel I proposal, too
many countries agreed to submit to the capital requirement in
theory, but not in practice. I want to be sure that U.S.
financial institutions of all sizes are not adversely impacted
as a result of Basel II.
There is no argument that Basel I should be updated to
better reflect the marketplace in which financial institutions
operate today. I want to thank again and applaud the authors of
Basel II for their hard work. I am concerned, however, that
this process is moving forward at the speed of light and
without assurances that there will not be any unintended
consequences for U.S. institutions and the U.S. economy as a
whole.
I very much look forward to hearing all your testimony, and
would again like to thank you for appearing before this
subcommittee. I might add that I am Congresswoman Judy Biggert
from the state of Illinois and vice chair of this committee,
and am sitting in for Peter King, the chairman, who had a
conflict today. So in case you have a strange face sitting in
this seat, that is why. So I appreciate that.
Now, I turn to the ranking member, Mrs. Maloney of New
York, for her opening statement.
Mrs. Maloney of New York. I thank the acting chairwoman,
and share many of the sentiments that she expressed in her
opening remarks. I am very pleased to welcome Comptroller Hawke
back to the committee, as well as Chairman Powell and Vice
Chairman Ferguson. It is good to see all of you again, and I
look forward to your testimony.
This morning's hearing focuses on a critically important
issue for our economy, and the safety and soundness of our
financial system-the new Basel Capital Accord, Basel II. The
first Basel Capital Accord established the minimum standard for
the banks that operate internationally. Basel II is an attempt
to build on this progress by allowing financial institutions to
hold capital in amounts more reflective of risk and changing
market conditions. Once implemented, the final Basel II Capital
Accord will have profound consequences for the banking
industry, our constituents, and the economy as a whole.
Capital standards that are too high cut off credit,
especially for borrowers with higher risk profiles. Capital
standards that do not adequately protect against loss, risk the
safety and soundness of the financial system. At this point in
the evolution of Basel II, I believe that there is much to
praise in the work of the committee, but serious areas of
concern remain.
The effort to align capital more closely with actual risk
is a significant improvement over the current one-size-fits-all
regime. At the same time, I share the concern expressed by some
regulators and banks about the complexity and competitiveness
issue raised by placing operational risk under Pillar I of the
new Basel Accord. Operational risk is defined as the risk of
direct or indirect loss resulting from inadequate or failed
internal processes, people, and systems, or external events.
These are extremely varied scenarios. They include potential
natural disasters, terrorist attacks, actions of rogue traders
and even litigation risk.
It is my opinion that any final accord not require U.S.
institutions to hold a higher amount of capital for operational
risk than foreign competitors. Our supervisors are the world's
most advanced and our institutions already have a contingency
plan and practice risk mitigation for disasters. Even after
September 11, when this attack in the heart of the world's
financial center, the financial system recovered relatively
well, given the scope of the disaster. I do not want to see
investments and businesses' continuity planning, backup systems
and insurance be reduced because institutions have to devote
resources to capital changes and charges for operational risk.
I am also troubled by the potential that U.S. institutions
could have to hold additional capital because of litigation
risk. In a sense, the U.S. would face the potential competitive
disadvantage because our laws protect individuals against loan
discrimination and allow them private rights of action.
In addition to operational risk, there are several other
issues that I hope will be addressed today. Basel II has yet to
decide how host home country application of the accord will be
implemented. If this is resolved incorrectly, there is the
potential for competitive disadvantage for U.S. institutions if
foreign banks are allowed to operate in the U.S. market under
capital standards established by their domestic regulators.
Additionally, some commentators are concerned that the accord
could result in much lower capital requirements for large
institutions, adding incentive for more consolidation in the
industry. Finally, I look forward to a discussion of whether
the final Basel Accord will increase the severity of business
cycles by requiring additional capital during economic
downturns and thereby contributing to credit crunches.
I thank the regulators for the thousands of hours they and
their staffs have contributed to this effort, and I look very
much forward to the testimony.
Thank you.
Chairwoman Biggert. Thank you.
We are very pleased to have the chairman of the committee
here today, Mr. Oxley. Mr. Oxley is recognized for an opening
statement.
Mr. Oxley. Thank you, Chairlady. Let us first of all
welcome our distinguished panel. It is good to have all of you
back to the committee, Mr. Ferguson from the Fed, Mr. Hawke
from the OCC, and of course FDIC Chairman Powell. Welcome back.
We look forward to a spirited hearing this morning on the
revisions of the Basel Capital Accord currently under
discussion at the Bank of International Settlements. We have
two very distinguished panels, and I look forward to both the
panels' testimony.
I want to first commend the Federal Reserve, the OCC, the
FDIC and the New York Fed Chairman McDonough in particular for
spearheading the reforms of the Basel Accord. The authors of
Basel II have been working diligently for nearly five years to
develop a workable regulatory capital regime. The primary goal
of Basel II is to provide flexibility and risk sensitivity in
the capital adequacy framework. This goal is laudable and will
be a vast improvement over the one-size-fits-all approach of
the Basel I Accord, and will certainly reduce risk arbitrage
under the current system.
This is a topic of critical importance to the banking
sector and the economy. If we must sacrifice speed to achieve a
workable and appropriate solution the first time, I see no
problem in doing so. Basel II will impact not only the largest
U.S. financial institutions, but financial institutions of
every size and structure. The way banks calculate risk and
compete with one another will be dramatically changed under
Basel II. Specifically, I am concerned that as it is currently
written, Basel II will force a medium-sized institution to
either consolidate to compete with the largest banks, or simply
cease to offer business lines that the largest banks can offer.
According to the Federal Reserve, Basel II will only be
mandatory for the 10 largest banks in the U.S., and will be
voluntary for the next 10 largest banks. My concern is, what
happens to the next 10 institutions and the 10 after those.
I believe that the proposed operational risk charge could
also result in unintended consequences, forcing banks to
quantify the risk of such intangibles as litigation risk,
employee fraud and system failure. Operational risk assessment
seems to be much more art than science, and could force
institutions to take large capital charges when there is little
need for them. Such charges may disadvantage domestic financial
institutions by requiring capital charges for factors that are
difficult to quantify and are significantly less likely to
occur in other countries.
Basel II is extremely sophisticated. The cost and
complexity of the proposed Basel II Accord could prove to be
overly burdensome for both the institutions and the regulators
charged with enforcing the new provisions. This proposal will
completely change the way that banks are overseen. As such, the
regulators are going to have to retrain and hire new staff and
develop new methods for bank supervision. We need to ensure
that all parties affected by these changes are prepared to
ensure the smooth implementation of Basel II.
In conclusion, I want to reiterate my support for the
reform of Basel I. There is no question that change is needed.
However, I strongly urge the Federal Reserve and the other
regulators to give serious consideration to all the comments
they hear today and the comments that will be made to the third
consultative paper before moving forward with any rulemaking. I
am troubled that a fast-track timeline for the completion of
the Basel II accord has already been established. I understand
that the authors of Basel II are seeking final rulemaking to be
completed by the end of this calendar year. For a regulatory
structure so complex and so far-reaching, we must take a
measured approach in order to ensure that all voices have been
heard, and that we mitigate or eliminate any unintended
consequences of Basel II to the banking sector and the U.S.
economy.
I yield back.
[The prepared statement of Hon. Michael G. Oxley can be
found on page 54 in the appendix.]
Chairwoman Biggert. Thank you, Mr. Chairman.
We are also pleased to have the ranking member of the
committee here today. Mr. Frank from Massachusetts is
recognized for an opening statement.
Mr. Frank. Thank you, Madam Chair. I want to express my
appreciation to my fellow bookend, the chairman of the
committee, for responding as he did when I and others brought
this to his attention, and arranging to have this hearing. I
think this is very important, and the chairman, I appreciate
his responding in this way.
I am going to take the opportunity of having Basel under
consideration, particularly with the Fed here, just to say on
an unrelated Basel topic, I was pleased to see the recent
change with regard to the risk factor and the time of loans. We
had a problem because I think there is a pretty good consensus
that internationally short-term capital has been a
destabilizing effect in some economies. To the extent that
capital went in and out in East Asia, for instance, that was
problematic.
It was called to my attention that to some extent
inadvertently Basel might have been contributing to that
because in the risk factor, short-term capital was considered
much less risky than long-term capital. That was a clear case
of a perverse incentive. I understand that there has now been a
modification so that short-term capital is considered, that it
is given some kind of benefit from this, that it is only three
months or less and that it is focused to a great extent on
trade-related. I hope we can sharpen that, because obviously it
would not make sense for us to be exaggerating an area of
instability. So I appreciate that. This is an example of how we
need always to fine-tune these things.
As to this particular subject, I am concerned by several
points that were raised to me by some of those who would be the
subject of the regulation, and that is obviously often where we
get our information. I am particularly concerned about the
potential negative competitive effects, both within the United
States and internationally. The function that is being
regulated here is one that is performed both by banks and by
institutions that are not banks. What has been raised to me is
the differential impact on the banks, obviously, who would now
be subject if it is a Pillar I approach to a capital charge,
versus competitors who would not be. That is not just a matter
of fairness, because we are not here to help one institution
versus another. It becomes a matter of incentives. It becomes
an incentive, to some extent, for institutions interested in
this not to be banks, or to be setting up institutions that are
not banks, so that we would wind up having set out to increase
the regulation, potentially have more of this being done in
entirely non-regulated areas. That is troubling.
I am troubled by the potential adverse effect that has been
raised by some and will be aired on American versus other
institutions, depending on how this carried out
internationally. I also am interested, and I particularly
appreciate all three of the regulators coming here. I guess we
have three out of the four. We do not have the thrift people,
but on this one, I suppose they are not involved. I am
interested in the legitimate differences of opinion among the
regulators. Let me say I hope no one will think that it is
somehow improper for various of the regulators to share with
the Congress of the United States differences they may have.
Once a regulation is promulgated by the appropriate processes,
I would expect everybody to be diligent in carrying it out. But
trying to paper over what might be legitimate differences in
opinion, particularly when we are talking about some fairly
technical matters, does not serve anybody well.
So I encourage all to speak out. We know there have been
some differences. We would expect that. There are institutional
differences. These are not easy questions to answer, and I am
appreciative.
I want to join the chairman, too, in cautioning against
excessive haste. I must say that when this was first brought to
my attention, I spoke to people. I had a very good briefing,
and I am very appreciative, that President Monahan of the
Boston Federal Reserve arranged for me. One of the first things
people told me was that this was nothing to be hasty about. I
was told that this was not anything imminent. To some extent, I
must say I am a little concerned when I was told that at the
beginning, and now I am told, well, you have got to hurry up. I
do not see any reason to hurry, and I hope that we will not be
told that we are now confronting any fait accompli, that we are
in plenty of time to do this.
There does appear to be, let me say in closing, a consensus
that we should have some regulation. Whether or not it should
be with a formalized capital charge versus increased
supervision is very relevant. Certainly while there are always
risks in various things, this does seem to me to be
qualitatively different from the risks that are involved when
you were talking about quantifiable loans. I think the capital
charge, a dollar reserve, a money reserve clearly has relevance
there. Where we are talking about this area, I must say if I
were coming at this myself ab initio would be more inclined to
the non-charge regulatory approach, but obviously we will
listen.
So I thank the chairman for calling the hearing and I thank
the three regulators for coming forward this way. I look
forward to what they have to say.
Chairwoman Biggert. Thank you.
Members will be recognized for three minutes, if they wish
to make an opening statement. Mr. Hensarling of Texas? Mr.
Murphy of Pennsylvania? Mr. Barrett of South Carolina? Mr.
Kennedy of Minnesota?
Mr. Kennedy. Thank you.
I would just echo the concerns that this does not create
the international competitiveness that puts American financial
institutions at a disadvantage. I am very interested in hearing
your testimony. Thank you for coming.
Chairwoman Biggert. Thank you.
Mr. Emanuel of Illinois?
Mr. Emanuel. Thank you. I obviously look forward to their
testimony and obviously the Q&A afterwards. Thank you.
[The prepared statement of Hon. Rahm Emanuel can be found
on page 56 in the appendix.]
Chairwoman Biggert. Okay. Ms. Lee of California?
Ms. Lee. Thank you, Madam Chair.
I just thank you for the hearing and look forward to the
testimony. Specifically, I would like to listen closely to how
Basel II really will affect smaller banks, as it relates to the
new capital requirement systems. I look forward to also
returning to my district to talk to our banks and
representatives in the Bay Area about it. Thank you.
Chairwoman Biggert. Thank you. Mr. Baca of California?
To our other members that are here, Mr. Lynch, do you have
an opening statement? Do you have a motion for unanimous
consent to make an opening statement?
Mr. Lynch. I do. I would ask unanimous consent that I be
allowed to make a statement, Madam Chair.
Chairwoman Biggert. Without objection.
Mr. Lynch. Thank you very much.
I do want to thank all of the witnesses here this morning
who have come forward to help the committee with their work. I
in particular want to thank David Spina and Maureen Bateman
from State Street Corporation for coming here today. I am
interested in hearing all of the testimony, but especially the
testimony of those institutions that will have to eventually
live under anything that is eventually adopted. I think that
Mr. Spina will be uniquely situated to address that
perspective.
I expect that at some point, Madam Chair, we are going to
be pulled out. There is a members only briefing with Tom Ridge
on homeland security at 11 o'clock. I hope that at some point
during the testimony here this morning and this afternoon, that
we will hear from all of those, and especially Mr. Spina, on
the specific issue of how will this regulation, especially
Pillar I of Basel II, how will that affect institutions that
have to work under that regulation going forward; how will that
affect, as others have mentioned, the competitiveness of some
of our institutions in this country. I want to echo the remarks
and the concerns, or amplify the concerns of Mr. Frank about
what this really would do in an international competitive
situation with some of the banks from the European Union.
I think there is much to be worked through in this. I hope,
again, as Mr. Frank said, that this is not a fait accompli and
that we really have an opportunity to look very hard at what we
are about to do here, and that we protect the institutions that
have protected our investors and our citizens so well in the
past.
Thank you, Madam Chair. I yield back my time.
Chairwoman Biggert. Thank you.
Mr. Capuano, would you have an opening statement?
Mr. Capuano. Yes, Madam Chairman. Again, I would ask
unanimous consent that I be able to make a statement.
Chairwoman Biggert. Without objection.
Mr. Capuano. Thank you, Madam Chair.
Again, I will be very brief. First of all, I thank you all
for coming here. I actually thank you very much for a lot of
the information we have gotten. This is a relatively
complicated area. Actually, it is a very complicated area, and
we need all the information we can get. I thank you all for
providing that.
For me, when I see these types of things, I see new
regulation. I have never been terribly opposed to regulation
per se. It is not a swear-word for me, but the question is
obviously reasonable, amounts of regulation is one thing. But
more important than anything else, which is my big concern with
the drafts that are here, is the concept of a level playing
field. I know it is nobody's intention to not create a level
playing field, but particularly with the new world that we have
in financial services, level playing fields are not necessarily
always made based upon the organizational structure of a
particular entity engaged in a business line.
Right now, I do not know what a bank is anymore. I know
people have charters, but who is a bank? Realtors are banks
sometimes. banks are sometimes realtors. Who is an insurance
company? Who is not? No one knows anymore. So for me, I would
simply encourage, and again, I am sure you have already
considered it, but as you continue, to strongly encourage that
you take the old concepts of organizational structure, knowing
that they are in flux, knowing that they are changing daily,
and to try to create that level playing field based on a
business line, as opposed to an organizational structure both
domestically and internationally. I know you are trying to do
that, but to me that is the most important aspect here, and I
look forward to helping you; or actually hopefully not having
to help you to create that level playing field.
Thank you.
Chairwoman Biggert. Thank you.
Let me just say before introduction of the witnesses that
there is a briefing at 11 a.m., but I intend to continue on
with the hearing. So I know that some of our members will be
leaving, but hopefully they will return following that
briefing, but we will continue with the hearing.
Let me now introduce the members of the first panel. Dr.
Roger W. Ferguson, Jr., was appointed to the Federal Reserve
Board in 1997 and has been vice chairman of the Board of
Governors since 1999. Dr. Ferguson was recently appointed
chairman of the Committee on Global Financial Systems at the
Bank of International Settlements in Basel, Switzerland. Before
becoming a member of the board, Dr. Ferguson was a partner at
McKinsey and Company, an international consulting firm. He
received a B.A. in economics, a J.D. in law, and a Ph.D. in
economics, all from Harvard University.
Next on our panel is John D. Hawke, Jr., who has served as
Comptroller of the Currency since 1998. Prior to his
appointment as Comptroller, Mr. Hawke served for three and a
half years as Undersecretary of Treasury for Domestic Finance,
where he oversaw the development of policy and legislation in
areas of financial institutions, debt management in capital
markets, and served as chairman of the advance counterfeit
deterrence steering committee and is a member of the Securities
Investor Protection Corporation. Mr. Hawke has a B.A. in
English from Yale University and a law degree from Columbia
University.
Donald E. Powell is the 18th chairman of the Federal
Deposit Insurance Corporation. Prior to being named Cairman of
the FDIC, Mr. Powell was president and CEO of the First
National Bank of Amarillo. He received his bachelor of science
degree in economics from West Texas State University, and is a
graduate of the Southwestern Graduate School of Banking at
Southern Methodist University.
Thank you all, gentlemen. Without objection, your written
statements will be made a part of the record. You will each be
recognized for a five-minute summary of your testimony. After
all of you have testified, then we will recognize members for
five minutes each to ask questions of you. If that is agreeable
with you, we will begin with Dr. Ferguson for your testimony.
STATEMENT OF ROGER W. FERGUSON, JR., VICE CHAIRMAN, BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Mr. Ferguson. Thank you very much, Acting Chairwoman
Biggert. Representative Maloney, members of the subcommittee,
and also Representative Oxley and Representative Frank.
It is a pleasure to appear before you on behalf of the
Board of Governors of the Federal Reserve System to discuss the
evolving new capital accord, Basel II. I would also at this
point like to thank my colleagues here at the table for their
active participation over the last four or five years in
developing Basel II, and to recognize the great work not only
of the Federal Reserve Staff, but also the staffs of the FDIC
and the OCC who have been active participants as well.
Basel II is a complex proposal with many associated issues,
but the format this morning requires that I be brief. As you
have already indicated, the board has prepared a longer
statement. I am pleased that this will be part of the record.
This morning, I will limit myself to only a few highlights from
that statement.
There are several points that I believe should be
emphasized at the outset before I address some of the questions
you have raised. First, in the United States, as Representative
Oxley has pointed out, Basel II will only be mandatory for a
small number of large, complex banking organizations; about
ten. Other entities may adopt it if they wish, although we do
not think it will be cost effective for any but the larger
organizations. All adopters, both mandatory and voluntary, will
be required to construct the necessary infrastructure to
produce and validate the key risk measurement inputs to the
Basel II framework.
Secondly, only those U.S. banks that adopt Basel II will be
required to hold capital for operational risk. Third, beyond
the required core group of ten or so, and what we expect at
least initially may be another ten or so adopters by choice,
all the other thousands of banks in this country will remain
under the current capital structure known as Basel I.
Finally, the process of developing the Basel II proposal
has not been hasty. It has involved a truly unprecedented
dialogue with banks on a wide range of risk management and
capital issues. That dialogue continues, and in fact will never
be over. The Basel Committee will soon be issuing a revised set
of proposals that we intend to use as the basis for a U.S.
domestic comment process during the spring and the summer. The
Basel Committee intends to approve a revised proposal late this
year, while we believe that the associated U.S. rulemaking
procedures, which will be the usual ANPR and NPR procedures,
will be completed some time next year. Again, I do not
necessarily believe that to be a hasty timetable.
Implementation could start as early as late 2006, but no
U.S. bank will be permitted to adopt Basel II until its
infrastructure for estimating the required inputs has been
approved by its supervisor. It is important to emphasize that
modifications to the Basel II proposals will be possible both
before and after these critical milestone dates. As
supervisors, we will be seeking continually to improve our
understanding of the impact of the new rules and will be
prepared to make necessary changes as appropriate.
With these preliminary observations, let me quickly sketch
out why we believe Basel II is necessary for the large,
complex, internationally active U.S. banks. First, while Basel
I is still quite effective for most banks, it is too simplistic
effectively to capture the increasingly varied and complex
operations of our largest banking organizations. Indeed, the
Basel I capital ratios are too often misleading. Congress, you
will recall, has required that these ratios be used as a
mechanism for filtering the activities of banking organizations
and guiding supervisory assessments of financial condition,
including the need for supervisory intervention. Unfortunately,
current trends will continue to erode the usefulness of the
existing capital ratios for the largest banks unless
significant steps are taken to address this concern.
Second, risk measurement and risk management practices have
improved dramatically since Basel I was created. Basel II is
designed to capture those changes and to induce banks to carry
them forward in their own internal risk management. Third, the
necessity to induce banks to apply stronger and more
comprehensive risk management techniques has been highlighted
and heightened by the increased banking concentration both here
and abroad. In this country, we now have a small number of very
large banks and bank holding companies whose operations are
tremendously complex and sophisticated. Weakness, let alone
failure, at any one of them has the potential for severe
adverse macroeconomic consequences. The regulatory entity for
these entities must therefore encourage them to adopt the best
possible risk measurement and risk management techniques.
If we do not move in this direction, the risk of a problem
at one or more of these entities will rise, providing us with
only two unattractive options; on the one hand, increased risk
of financial instability, or the adoption of much more
intrusive supervision and regulation.
Time does not permit me to describe the mechanics of the
Basel II proposal, its risk inputs, regulatory formulas, use of
internal estimates, et cetera. These are all in my longer
statement, which again I urge you to read for your background.
I would like instead to spend my remaining time addressing a
small number of issues that some banks have raised with you and
with us.
A key feature of the Basel II framework is an explicit
capital requirement for operational risk; the risk that losses
can incur not from extending credit, but rather because
processes, systems or people fail, or some events occur. This
aspect of Basel II has generated aggressive criticism from
those who feel that it would affect them adversely. But
clearly, operational risk is real, and indeed often produces
noteworthy losses; rogue traders, fraud and forgery, settlement
failures, inappropriate sales practices, poor accounting and
lapses of control, slippages in custodian and asset management,
and large legal settlements for alleged losses caused by bank
action or inaction.
Indeed, I think my fellow supervisors would agree that our
staffs have spent no little time dealing with operational risk
issues in the last several years. Basel I bundled op risk with
credit risk, which is to say it effectively ignored it. An
early decision was made in the development of Basel II to
unbundle other risks from credit risk, and to treat each
explicitly. Most of the other risks are sufficiently modest so
that they can be addressed by supervisory oversight, but the
Basel Committee decided that operational risk is so important
that it should be treated similarly to credit risk, with an
explicit capital charge.
The current Basel II proposals reflect this treatment, and
thus the large U.S. banks required or opting to use the
internal ratings-based Basel II capital requirement will also
be required to hold capital.
Chairwoman Biggert. Dr. Ferguson, if you could sum up. I
think we will get to a lot of this in the questions also.
Mr. Ferguson. Okay. I have a number of other points to
make, but I am looking forward to responding to your questions
in that regard.
Let me also, if I could, speak to one other issue, and then
conclude by saying that there is clearly strong agreement among
the regulators that it is important to move past Basel I. I was
pleased to hear the subcommittee in the opening comments
address that. There are a number of technical issues which I am
eager to address today, but at this stage I will sum up and
allow others to speak.
Thank you.
[The prepared statement of Roger W. Ferguson, Jr. can be
found on page 74 in the appendix.]
Chairwoman Biggert. Thank you very much, Dr. Ferguson.
Mr. Hawke?
STATEMENT OF HONORABLE JOHN D. HAWKE, JR., COMPTROLLER, OFFICE
OF THE COMPTROLLER OF CURRENCY
Mr. Hawke. Thank you, Madam Chairwoman, Congresswoman
Maloney, Chairman Oxley, Ranking Member Frank, and members of
the Subcommittee. I am pleased to have this opportunity to
present the views of the OCC on the Basel Committee's proposed
revisions to the 1988 Capital Accord. I think it is essential
that Congress have the opportunity to express its views on any
regulatory changes that could affect the operations and
competitiveness of our banking system, and the Subcommittee is
to be commended for its initiative in this regard.
For the past few years, the Basel Committee, of which the
OCC is a permanent member, has been working to develop a more
risk-sensitive capital adequacy framework. The Committee has
established a target date of December 2003 for the adoption of
a revised Accord Basel II. Accordingly, the OCC and the other
U.S. banking agencies have already begun the process of
considering revisions to the current U.S. capital regulations
through our domestic rulemaking process. This means publishing
proposed revisions for public comment and carefully considering
the comments that we receive.
I want to assure the Subcommittee that the OCC, which has
the sole statutory responsibility for promulgating capital
regulations for national banks, will not sign off on a final
Basel II framework until we determine through this notice and
comment process that any changes to our domestic capital
regulations are reasonable, practical and effective.
Despite the enormous effort and great progress made by the
Basel Committee, serious questions remain about some aspects of
the Basel II framework. The first issue is complexity. One of
the goals of Basel II is to encourage financial institutions to
improve their own ability to assess and manage risk, and for
supervisors to make use of bank self-assessments in setting
regulatory capital. But before we can do that, banks have to
demonstrate that their systems, and the capital determinations
that flow from them, are reliable.
Thus, Basel II sets detailed and exacting standards for
rating systems, control mechanisms, audit processes, data
systems and other internal bank procedures. This has led to a
proposal of immense complexity--greater complexity, in my view,
than is reasonably needed to implement sensible capital
regulation. I believe we have to avoid the tendency to develop
encyclopedic standards for banks, which minimize the role of
judgment or discretion by banks applying the new rules or
supervisors overseeing them.
Moreover, Basel II has to be written in a manner that is
understandable to the institutions that are expected to
implement it, as well as to third parties. We have already seen
problems in understanding the instructions for the qualitative
impact study that has just been finished. It is imperative that
the industry and other interested parties understand the
proposed regulatory requirements.
The second issue is competitive equality. We need to think
carefully about the effects of Basel II on the competitive
balance between domestic banks and foreign banks, between banks
and non-banks, and between large internationally active banks
in the United States and the thousands of other smaller
domestic banks.
In the United States, we have a sophisticated, hands-on
system of bank supervision. The OCC has full-time teams of
resident examiners on-site at our largest banks--as many as 30
or 40 examiners at the very largest. In other countries, by
contrast, supervisors may rely less on bank examiners and more
on outside auditors to perform certain oversight functions.
Given such disparities in the methods of supervision, it seems
to us inevitable that an enormously complex set of rules will
be applied much more robustly under our system than in many
others. Thus, the complexity of the rules alone will tend to
work toward competitive inequality.
There is also a concern about the potential effect of Basel
II on the competitive balance between large banks and small
banks. As it is likely to be implemented in the U.S., Basel II
would result in a bifurcated regulatory capital regime, with
the largest banks subject to Basel II-based requirements and
all others subject to the current capital regime.
We expect that banks subject to Basel II will experience
lower capital requirements in some lines of business than banks
that remain under the 1988 Accord. That may put smaller ``non-
Basel'' banks at a competitive disadvantage when competing
against the large banks in these same product lines. We should
avoid adoption of a capital regime that might have the
unintended consequence of disrupting our current banking
structure of small, regional and large banks, and take steps to
mitigate the adverse effects on the competitive balance between
our largest and other banks.
Finally, for many banks, the principal source of
competition is not other insured depositories, but non-banks.
This situation is especially common in businesses such as asset
management and payments processing. While differences in
regulatory requirements for banks and non-banks exist today,
many institutions have voiced concern that implementation of
Basel II may exacerbate those differences to the disadvantage
of depository institutions.
The third issue is operational risk, perhaps the most
contentious aspect of the proposed revisions to the Basel
Accord. The OCC supports the view that there should be an
appropriate charge for operational risk. But I have also
consistently argued before the Basel Committee that the
determination of an appropriate charge for operational risk
should be the responsibility of bank supervisors under Pillar
II, rather than be calculated using a formulaic approach under
Pillar I. I regret to say that I have not been able to persuade
the Committee to adopt this approach.
Basel's operational risk proposal has changed considerably
since it was first introduced. The current proposal, especially
the option of the Advanced Measurement Approach (AMA), which
the OCC helped develop, is a significant improvement over
earlier proposals. The AMA is a flexible approach that allows
an individual institution to develop a risk management process
best suited for its business, control environment and risk
culture. Nevertheless, the OCC believes that more work needs to
be done to develop guidelines for the appropriate treatment of
operational risk.
Finally, calibration. It has been a specific goal of the
Basel Committee that the revised Accord be capital neutral. In
other words, the aim is to maintain the overall capital of the
banking industry at levels approximately equivalent to those
that exist under the Basel Accord today. To ensure that overall
capital in the banking system does not fall, the Committee has
proposed the use of a minimum overall capital floor for the
first two years following implementation of the new Accord.
While the OCC supports a temporary capital floor, it does
not believe that a reduction in minimum regulatory capital
requirements for certain institutions is, in and of itself, an
undesirable outcome. A drop in required capital is acceptable
if the reduction is based on a regulatory capital regime that
reflects the degree of risk in that bank's positions and
activities. But, we are not yet at the point where we can
really make a confident judgment about the impact of Basel II
on capital levels. QIS-3, the latest qualitative impact study,
was based on an incomplete proposal and was applied by the
banks without any of the validation or control that would be
present when the new regime is in full force. Thus, an effort
to calibrate new capital requirements based on QIS-3 must
confront great uncertainty. This uncertainty further
illustrates the importance of moving cautiously before we
incorporate Basel II into our domestic capital rules.
In conclusion, as I indicated earlier, the OCC strongly
supports the objectives of Basel II. This summer, the OCC and
the other banking agencies expect to seek notice and comment
from all interested parties on an advanced notice of proposed
rulemaking that translates the current version of Basel II into
a regulatory proposal. If we determine through our rulemaking
process that changes to the Basel proposal are necessary, we
will press the Basel Committee to make changes. We further
reserve our right to assure that any final U.S. regulation
applicable to national banks reflects any necessary
modifications. Given the importance of this proposal, we need
to take whatever time is necessary to develop and implement a
revised risk-based capital regime that achieves the stated
objectives of the Basel Committee, both in theory as well as in
practice.
Thank you very much.
[The prepared statement of Hon. John D. Hawke, Jr., can be
found on page 94 in the appendix.]
Chairwoman Biggert. Thank you.
Mr. Powell, you may proceed.
STATEMENT OF HONORABLE DONALD POWELL, CHAIRMAN, FEDERAL DEPOSIT
INSURANCE CORPORATION
Mr. Powell. Thank you, Madam Chair and members of the
Subcommittee.
Since 1999, the Basel Committee has worked hard to develop
a new international capital framework referred to as ``Basel
II.'' I entered this effort late in the game, having joined the
FDIC eighteen months ago, and I am grateful to my fellow
supervisors and their staff for the efforts to get us where we
are today.
Bank capital is critical to the health and well-being of
the U.S. financial system. An adequate capital cushion enhances
the banks' financial flexibility and their ability to weather
periods of adversity. The conceptual changes being considered
in Basel II are far-reaching. For the first time, we would
create one set of capital rules for the largest banks and
another set of rules for everyone else. Under the proposed new
Accord, large banks will feed their internal risk estimates
into regulator defined formulas to set minimum capital
requirements. Under the new formulas, minimum capital
requirements for credit risk would tend to be reduced, with
additional capital being held under a flexible operational risk
charge.
Admittedly, the existing capital rules for the largest
banking organizations have not kept pace with these
institutions' complexity and ability to innovate. Basel II
intends to align capital with the economic substance of the
risks large banks take. That is a worthy goal. Nevertheless,
before regulators and policymakers embrace Basel II, the FDIC
has concluded that three critical issues need to be addressed.
First, minimum capital requirements must not be unduly
diminished. Lower capital requirements for credit risk,
together with a set of more flexible capital charges imposed by
supervisors, may work well in theory. Experience demonstrates,
however, that it is difficult for supervisors to impose
substantial capital buffers in the face of stiff bank
resistance, especially during good economic times. Substantial
reductions in minimum capital requirements for the largest U.S.
banks would be of grave concern to the FDIC.
Second, we must be satisfied that the regulators can
validate the internal risk ratings. By allowing the use of
banks' internal risk estimates, Basel II represents a
significant shift in supervisory philosophy. This new
philosophy demands that we have in place uniform and consistent
interagency processes that are effective in assessing whether
the banks' internal estimates are reasonable and conservative.
These processes are being developed by the agencies, but the
work here is not final.
Third, we must understand and assess the competitive impact
of Basel II. Basel II will most likely be mandatory only for a
group of large, complex and internationally active U.S. banking
organizations. This mandatory group of institutions does not
include numerous large regional banking institutions, as well
as thousands of smaller community-based banks and thrifts. If
Basel II provides the largest U.S. institutions some material
economic advantage as a result of lower capital requirements,
the ``non-Basel'' institutions may find themselves at a
competitive disadvantage in certain markets. This
``bifurcated'' system raises the concerns of competitive
inequity between these groups of banks.
banks themselves are best equipped to evaluate these
issues. We regulators, in turn, must provide them with
straightforward dollars and cents information about the Accord
and the capital they or their competitors may be required to
hold.
The FDIC will work with our fellow regulators to address
these issues in the months ahead. Presuming these threshold
issues are satisfactorily resolved, numerous Accord
implementation issues still need to be decided. I will touch on
two of them in my remaining time. To fully adopt the internal
ratings-based approach proposal in Basel II, banks must make
significant investments in staff expertise, internal controls,
and make the necessary structural and culture changes.
Qualifying for and living with Basel II will bring complexity
and burden. Of course, a degree of regulatory complexity is
unavoidable as banks seek to have capital tailored to their
individual risk profiles. But these burden considerations, and
the desirability of testing the waters with the new Accord,
suggest that the universe of ``Basel II banks'' initially will,
and should be, relatively small.
The proposed capital charge for operational risk has
attracted much discussion. Bank failures related to operational
risk can be traced overwhelmingly to one common theme-fraud.
This is certainly part of the reason banks hold capital.
Whether the operational risk charge is called Pillar I or
Pillar II is not of critical significance to the FDIC, provided
the regulators implement this approach in a commonsense,
flexible manner.
Finally, in implementing the Accord, let us not overlook
the importance of credit culture and the virtues of
conservative banking. The Basel II internal risk estimates are
likely to be only as robust as the credit culture in which they
are produced. Rigorous corporate governance structures,
effective internal controls and a culture of transparency and
disclosure, all play an important role in ensuring the
integrity of the banks' internal risk estimates. It will be
important for supervisors not to place excessive reliance on
quantitative methods and models. Models can be wrong and losses
can depart from historical norms. That is why we need a margin
for error. To repeat an earlier point, that is why we need
capital.
Thank you.
[The prepared statement of Hon. Donald Powell can be found
on page 145 in the appendix.]
Chairwoman Biggert. Thank you very much. We will now have
questions. I will yield five minutes to the chairman of the
Financial Services Committee, Mr. Oxley.
Mr. Oxley. Thank you, Madam Chairwoman. I appreciate that.
Gentlemen, Mr. D. Wilson Ervin, representing Credit Suisse
First Boston, will be testifying on the second panel. Always a
problem with the second panel is that members are distracted
and so forth, so I was looking over his testimony and he had
some very pointed criticisms of Basel II and I thought maybe I
would bring them up with you, and see how you respond. While
giving some very good support and praise for the work of this
project, he cites four macro issues that arise out of the
proposed accord that he has some problem with. I would just
like to ask each one of you to respond to those specific macro
concerns.
The first one is, as Mr. Ervin says, the current Basel
proposal is too complex, too costly, and too inflexible to
provide a robust, durable framework for bank supervision going
forward. Implementing the proposed accord may have the effect
of freezing the development of good risk management and locking
it into an "early 2000" mindset. I am not quite sure what that
means, but that is a good place to start.
Dr. Ferguson?
Mr. Ferguson. Certainly. I appreciate your giving me a
chance to respond to this. First, on the question of
complexity, the answer is Basel II is more complex than Basel
I. There is no doubt about it. The question of why it is
complex is the key issue here. It is complex because Basel I
was a one-size-fits-all, very simplistic approach that did not
reflect or does not currently reflect the way the largest banks
manage their capital and manage their operations. As we went
forward with Basel II, in consultation with the industry, as we
came out with a variety of proposals, many in the industry
asked for a slightly different approach, more flexibility,
different options. What one ended up with was indeed a system
that moved from one-size-fits-all to a system that is
appropriately much more risk-sensitive, that reflects the range
of activities that banks undertake, the range of risks that
they take, and consequently is more complex.
So the question is not that it is too complex, but I think
it is complex because it reflects the complexity of the banking
industry.
Mr. Oxley. What about too costly?
Mr. Ferguson. Second question, costly. I think of cost in
terms of the cost-benefit analysis. There are two ways that I
have thought about this cost problem over the last year or so
when I have been actively involved in this hands-on way.
First, many of the largest institutions are already going
down this path. As I have gotten involved with this, as I have
worked with the staff, I have discovered a large number of our
large and complex institutions already approach risk management
in a way that is quite similar to what Basel II is doing. They
need some incentive. They need some encouragement. Some are
laggard, which is one of the reasons why going in this
direction is appropriate, but they have found it in their own
business interest to start to manage in a way that is quite
consistent with what Basel II has asked for.
The second question with respect to cost is what is the
benefit that one gets out of it, because it is more costly than
simplistic approaches, but on the other hand there are clear
business benefits, and I think national benefits to having
banks that are managed in a way that focuses much more on the
variety of risks that they face and the various portfolios, and
recognize that there is more than a one-size-fits-all approach.
So I look at this in terms of cost-benefit, not just being too
costly.
Mr. Oxley. Too inflexible?
Mr. Ferguson. I think that is also a misunderstanding. As I
tried to indicate in my opening remarks, one, I think Basel II
and the interaction and development of Basel will allow for an
ongoing improvement with respect to Basel. As my colleague Mr.
Hawke indicated, the expectation would be that this would be
implemented originally in the very first part of 2007, but
there would be ongoing review through 2008 and 2009. So there
is a chance to continue improvements. Obviously, through both
Pillar I, Pillar II, and Pillar 2I, as new risk management
techniques take hold, and there are new ways of estimating some
of the important parameters, that the business community
developed, the banking community develops, or that we develop,
those can and will be reflected in the capital requirements.
All we are asking banks to do is estimate some parameters, but
the process by which they estimate them, as long as we as
regulators can validate them, can and should evolve over time
with the best risk-management technology and techniques that
emerge as we go into the 21st century.
Mr. Oxley. Thank you, Dr. Ferguson.
Let me just go to Mr. Hawke. Complex, costly, inflexible?
Mr. Hawke. Mr. Chairman, here on the table is the current
version of Basel II. It is infinitely more complex than it
needs to be. It is not complex simply because we are dealing
with a complex subject. It is not only complex, it is virtually
impenetrable. I defy ordinary people to get past page three or
four of most of the parts of this document.
Mr. Oxley. Ordinary people do not read that stuff.
[Laughter]
Mr. Hawke. Ordinary people called bank examiners have to
apply it.
Mr. Oxley. You are calling bank examiners ordinary people?
[Laughter]
Mr. Hawke. That is not a slur.
[Laughter]
It is complex because it reflects a mindset on the part of
a controlling view in the Basel Committee that this needs to be
a highly prescriptive document that addresses every nicety and
every aspect of capital regulation. Every loophole is plugged.
Every nuance is addressed. It reflects a pathological aversion
to the exercise of supervisory discretion. That is why it is as
complex as it is. It does not need to be this complex, and I
have argued this point in the Committee for the past four
years.
Second, as to whether it is too costly or not, I think that
depends on what the final impact is. If the capital of banks is
really reduced to a point where it is better reflective of risk
and that reflects a capital saving, then the cost may be
entirely justified.
And, quickly, as to the final point, whether it locks us
into a year 2000 approach to risk measurement, I have thought
for a long time that that was a danger. We have in a sense here
a governmentally dictated approach to capital measurement. It
is an approach that has an awful lot to say for it. But it is
our approach, and banks are going to have to make an investment
in implementing the approach that we put out there in final
form. That does run the risk of inhibiting the development of
new and better risk measurement systems, because banks will
already have made the investment in the system that we have
told them that they are going to have to follow. So I think
that is a danger.
Mr. Oxley. Thank you.
Chairman Powell, could you give us a succinct Texas
response to those three issues?
Mr. Powell. First of all, I have never met a normal
examiner.
[Laughter]
I am just kidding. Again, being a former banker, I have
never seen a regulation that was not complex. They tend to be
all complex. I think there is a need for a certain complexity
in the regulations. Having said that, I think as it evolves
over time, the complexity is diluted to some extent in real
practice. I think regulators have a history of working with
institutions to resolve complexities. So I am not as concerned
as much about the complexity as some, and perhaps it should be
complex. I am more concerned about making sure that Basel II
maintains adequate capital ratios. I think it is necessary. I
think it is important when we are addressing deficiencies
within the system. We must and should have better risk models.
Whether those models are more complex, again, depends upon the
view. But my overriding concern is that those models do not
produce watered-down capital requirements of these that are in
existence today.
Mr. Oxley. Thank you.
Thank you, Madam Chairwoman.
Chairwoman Biggert. Thank you.
Mrs. Maloney, the ranking member, is recognized for five
minutes.
Mrs. Maloney of New York. I defer to the ranking member,
Mr. Frank.
Mr. Frank. I thank the gentlewoman. I want to say, as I
read this, part of what I get is that when people have said
this should have been Pillar II instead of Pillar I, the
defense in part is yes, but it is a Pillar I that looks like
Pillar II. Well, if it looks like Pillar II, why don't we make
it Pillar II. Mr. Ferguson?
Mr. Ferguson. Again, a good question. Let me explain what
it does do and how it is different from Pillar II. The
importance of Pillar I falls into three categories, Congressman
Frank. One is transparency. Under Pillar I, you disclose the
capital that you are holding for a particular purpose.
Mr. Frank. Let's do these one at a time. Is there anything
that would stop you from saying it is Pillar II, and as a
transparency requirement, that as part of your administering it
as a Pillar II, you would require that that amount of capital
that you can show be made public?
Mr. Ferguson. There is nothing that stops us from going
that route.
Mr. Frank. I just like to do things one at a time. It seems
to me on transparency we have got a tie.
Mr. Ferguson. Absolutely right. Let me go to Pillar II, the
other elements of why Pillar I is important. Pillar I allows
for more rigor in this process, and I frankly have to disagree
with some of the tone I have heard from the subcommittee that
this is very hard to quantify. There are a number of banks that
already are doing risk management and risk measurement in the
area of operational risk. Though not as quantifiable as credit
risk, I would admit, it is more than just sort of a vague gut
instinctive feel. Through the use of databases and a variety of
statistical techniques, which I would admit are complex, it is
possible to do a better job of quantification than perhaps some
might think, and there are banks that are doing that.
Now, the difference between Pillar I and Pillar II in that
regard is that the enforcement of a rigorous, more easily
quantifiable, more verifiable approach works much better under
the authority of Pillar I than the give and take, back door,
quiet negotiation that exists under Pillar II.
Mr. Frank. I appreciate that. Let me ask you, then, about
this one. The banks that have quantified this, do you think
they have on the whole come up with adequate capital set asides
to meet those risks under the current situation?
Mr. Ferguson. The answer is I believe that is probably
true. Let me elaborate. It is not just the banks that have
quantified it in the way that we are thinking about.
Mr. Frank. I understand. I appreciate it. You know, this is
not the easiest stuff in the world, so you have got to be a
little bit compassionate towards some of us who are learning
this because this is our job. To be honest, I do not expect
this to be coming up at a town meeting, even if I had one, and
I do not have one. I need to go one at a time here. I am just
talking now; you said that some people have said that it cannot
be quantified, and you have said it can be with a reasonable
approximation. We know you do not get precision.
My question, then, is very specific. To the extent that you
are familiar with those that have quantified, have they tended
then; have they put up enough money? The second part of that
question would be this, under the Pillar I approach, would the
amount of capital a bank would be required to put up
approximate what they are now doing--those that have
quantified?
Mr. Ferguson. You have led me to the point that I wanted to
get to anyway, thank you very much.
Mr. Frank. If I got to where you wanted to go, maybe it was
not such a good way.
[Laughter.]
Mr. Ferguson. Two responses to your two questions. First,
the answer, as I quickly check with staff here, yes, we would
say that those that have been on the cutting edge in terms of
using a more quantified approach to operational risk have ended
up with a result that seems to us to be within the ballpark of
reasonableness; point one.
Point two, one of the major issues that one must understand
in this discussion is that many of the banks that are most
vociferous in opposition, and in fact the vast majority of U.S.
banks, hold excess regulatory capital. The total amount of
capital that we think would be required by quantifying op list
would not go up. The difference would be in transparency and
disclosure, because it would become clearer that they are
holding some of that capital that they now describe as excess
specifically for operational risk.
Mr. Frank. But we have agreed that you could under a Pillar
II approach deal with that by requiring that.
Mr. Ferguson. Right, but I am responding to your question
about whether the total amount of capital would have to go up,
and the answer is no, the total amount would not.
Mr. Frank. Let me ask you one last question, and then I
want to turn to the others briefly. The people who make the
decision to avail themselves of this capacity, the storage. We
are talking here about people who decide they are going to have
one of these banks be the place where they store stuff. My
impression is we are not talking here about individual
consumers, but entities that are themselves sophisticated
institutions. Is that generally correct?
Mr. Ferguson. Yes, generally speaking.
Mr. Frank. Okay. Then here is my question, because I raised
the question in some informal conversations, why we could not
just do it with publicity, et cetera, and people said, well,
why doesn't that work for deposit insurance, and does that mean
you have to have deposit insurance. It was a reasonable
question. I thought about it, and of course part of the problem
is that many of the people who make a decision to put their
accounts in a bank are unsophisticated consumers or they may be
people who are sophisticated about some things, but the
transactions costs of trying to figure out what was a safe bank
and what was not would be impossible. I put myself in that
category. I want to put my money in a bank. I do not want to
have to check all these other things.
But with regard to the people who avail themselves of this
particular service, it would seem to me that if you went ahead
and used the transparency authority you had and published how
much capital they had, et cetera, made them publish it, and if
in fact you thought it was inadequate and said so, that given
the sophisticated nature of the consumer in this case, that
that would be a pretty good protection. What is the matter with
that?
Mr. Ferguson. I think that it does not reflect two major
points here. One is, as I have said, the negotiation and the
discussion between the regulators and the institutions is one
in which having the Pillar I capability allows us to get to
reasonable answers.
Mr. Frank. One point at a time. Wouldn't the fact that you
might issue a statement saying you thought that the amount they
set aside was inadequate; would not that be a pretty effective
tool for you to use, given the again sophisticated nature of
the consumer?
Mr. Ferguson. That would be a dramatic change in the
relationship. One of the things that happens in supervisory
relationships is that by and large, unless an institution goes
to the point that we need to have a public memorandum of
understanding or a cease and desist order, we keep confidential
the regulatory information. For example, we do not publish the
so-called CAMEL rating. So to move into a position where in
lieu of using Pillar I we are in a name-and-shame mode, a
whistleblowing mode, changes the confidential relationship that
we normally have with institutions. I would prefer not to do
that for the sake of operational risk.
I think this Pillar I approach allows the right kind of
discussion and the right kind of transparency, without putting
us in the awkward position of disclosing confidential
information about how we consider banks in terms of, if you
will, a rating. That is the implication of what you just said,
and it is quite a change from the way that we normally deal
with banks. I do not think you really want us to go down that
path.
Mr. Frank. No, my feeling is that the fact that you might
do it would give you as much leverage as you needed.
Mr. Ferguson. Yes, but what I have said is that the reality
is that the banks know that historically we have not done that,
and in fact we are by our own rules and regulations--
Mr. Frank. You historically have not given them a charge
for this kind of risk, either. The whole purpose of this is to
change the history.
Mr. Ferguson. Let me respond to your other question, which
is whether or not sophisticated counter-parties would have a
general sense. The answer is that even for sophisticated
counter-parties, they may have a general sense of management,
but in fact they really cannot look into these opaque
institutions with the same clarity that the management itself
has, and indeed in many cases the management itself uses. One
of the things that you must understand is that Pillar I, or
this entire approach, so-called advanced measurement approach,
depends on the bank's management measurement tools with respect
to operational risk. In some situations, we are leveraging
their strengths and their internal view to develop capital, as
opposed to only on externals.
Mr. Frank. That is another question. If the bank does not
have good internal management, then Pillar I is not going to
work so well with them?
Mr. Ferguson. No. The point of Pillar I, and using all
three Pillars in this case, is to provide the banks with the
right set of incentives to manage as we know the leading edge
banks can do, and as we know many of the other large banks are
starting to do already, which is not; while it is a relatively
nascent science to compare their credit risk, this is not
something which the people on panel two or any other leader of
one of the major banks has a complete lack of experience or
exposure. So we are trying to give them the incentive to keep
going down a path that we, and I would think they, should be
on.
Mr. Frank. I appreciate it. I have taken too much time. I
have some other questions, but I will submit them.
Chairwoman Biggert. We will have another round.
Let me ask the next question, and I will direct it to the
other two gentlemen, although it really does apply to all three
of you, but we can come back to that. I really do not want the
answer; it is a question that is similar, but there are other
things in here that I would like you to address, rather than
what has just been talked about.
It is my understanding that the operational risk will
include a charge for the potential costs associated with U.S.
tort liability, discrimination, suitability and similar laws,
most of which do not apply in the European Union or in Japan.
Would not such a capital charge have an adverse competitive
impact on U.S. banks, and perhaps reduce compliance efforts? I
wonder if you could give the subcommittee any examples of where
the costs associated with compliance or litigation have
resulted in a bank failure. If not, why impose a capital charge
related to them? Would more effective supervision then enhance
both the social policy goals of these rules and reduce the
operational risk?
Mr. Hawke?
Mr. Hawke. I am frequently asked the question about whether
operational risk events have resulted in bank failures. One has
to scramble to try to find examples of that. There are probably
one or two, but there is no question that operational risk
events have resulted in significant loss. I do not think the
test of failure is necessarily the right one.
Differences between the United States and foreign
countries, in things like tort liability may well exist,
reflecting differences in risk between banks operating in those
jurisdictions. If our banks are subjected to greater potential
risk because we have a more refined system of tort liability,
that is a real risk that they face. It may indeed result in
some kind of competitive inequality.
Chairwoman Biggert. Mr. Powell, do you have anything to
add?
Mr. Powell. I would not have anything to add except this.
While Comptroller Hawke indicated that he is not sure that
should be the test as it relates to operational risk, I would
agree with him. We would be hard-pressed to find that
institutions have failed on a regular basis because of
operational risk. Some of these operational risks are
insurable. One can purchase insurance for that risk.
Having said that, clearly operational risk is very real in
the marketplace, and capital should be allocated. We at the
FDIC believe that there should be supervisory flexibility in
addressing operational risk. As we indicated, we really have no
preference whether it is in Pillar I or Pillar II.
Chairwoman Biggert. Then saying that, is there any
flexibility in Pillar I for operational risk?
Mr. Hawke. Madam Chairwoman, I think the important thing to
understand about operational risk is that there are at least
three components that need to be addressed in assessing it. One
is the nature of the risk; another is the quality of the
controls that the bank has to address the potential risk. The
third would be the quantification of that risk and the
translation of that quantity into some kind of capital charge.
All those things would have to be done whether this was
nominally under Pillar II or Pillar I. I have argued in the
Committee consistently that this should be a Pillar II exercise
because so much of it is subjective in nature: the evaluation
of internal controls, the evaluation of the nature of the risk.
But ultimately, it comes down to a question of quantification
and determining how much capital should be held against those
risks.
I think that the advanced measurement approach that we have
developed, which is nominally a Pillar I approach, takes into
account an appropriate degree of subjectivity. It is still a
work in progress. We still have to make sure that it works
right, that we are approaching the quantification issue, and
the capital charge that results, in an appropriate way. But
from my point of view, the good thing about the AMA approach is
that it infuses a substantial amount of supervisory discretion
into the process, the same kind of supervisory discretion we
would have had if this had been under Pillar II.
Chairwoman Biggert. Thank you. My time has expired. The
gentlewoman from New York?
Mrs. Maloney of New York. Thank you.
Earlier I wrote Comptroller Hawke and others about my
concern about the global competitive nature of the financial
services industry, and the concern that American institutions
not be placed at a disadvantage. He wrote back, and I would
like to place both letters in the record, and expressed some of
the testimony that he is giving today on the Pillar I versus
Pillar II, for the charge or operational risk. He has testified
that the advanced measurement approach appears to add more
flexibility. I would like to put his letter in the record. I
think it is very clarifying and important.
Chairwoman Biggert. Without objection.
[The following information can be found on page 171 through
173 in the appendix.]
Mrs. Maloney of New York. I would like to follow up on what
you are saying on how in the world do you resolve the
differences when you have a disagreement, as you have expressed
today, between Pillar I and Pillar II, for the charge for
operational risk? When we get to rulemaking, there will be
differences of opinion, and the OCC has oversight for national
banks, the Fed for holding companies; if you disagree, how do
you resolve it? Who has the final trump card?
Mr. Hawke. We spend a great deal of time trying to work out
interagency differences. I think that effort has been
enormously successful. We have common objectives and have
worked very well together. I do not anticipate that that will
change going forward.
As I mentioned in my testimony, the OCC has the sole
statutory responsibility for determining capital requirements
for national banks. In the theoretical event that we do not
come to closure with our colleagues at the Federal Reserve on
an approach, national banks would be subject to whatever
regulatory requirements we imposed on them. The Federal Reserve
has authority to set the capital requirements for holding
companies and non-bank subsidiaries of holding companies, but
that ability to set holding company capital is not intended to
supplant the judgment or authority of the primary supervisor
with respect to the banks. Holding company capital is intended
to protect the bank from the holding company, not to protect
the holding company from the bank.
I think our respective roles are pretty well spelled out by
statute, but I do not anticipate that if this process works the
way it should that we will end up having significant
differences.
Mrs. Maloney of New York. Comptroller Hawke, why is a
capital charge being proposed for operational risk when there
is no comparable one for interest rate risk? While significant
problems remain quantifying and measuring operational risk,
many of which you have pointed out today with your colleagues,
interest rate risk is priced daily by well-understood
methodologies. So why omit interest rate risk from Pillar I,
when it has been the cause of bank failures, while subjecting
operational risk to it? Why are we taking that away from Pillar
I when we know there have been bank failures, and you testified
you do not even know if there have been bank failures in
operational risk.
Mr. Hawke. That is a question that got raised and
negotiated very early in the Basel discussions. There were a
number of us in the U.S. delegation who felt that interest rate
risk ought to be included in Pillar II. As I said, I felt that
operational risk ought to be included there as well. In early
negotiations in the Basel Committee, it was agreed that
interest rate risk would be treated as a Pillar II item, with
attention focused on outliers in the spectrum of interest rate
risk.
Mrs. Maloney of New York. Why shouldn't it be in Pillar I?
Mr. Hawke. I think one can make an argument that it should
be in Pillar I. It is probably easier to quantify.
Mrs. Maloney of New York. Much easier to quantify than
operational. So why is it not in Pillar I versus operational?
Mr. Hawke. Interest rate risk is a lot easier to deal with.
banks deal with it all the time. The concern with respect to
interest rate risk was not the run-of-the-mill kind of risk,
but the risk presented by outliers who have significant mis-
matches and different kinds of portfolios. It was thought that
there was more room for supervisory discretion.
Mrs. Maloney of New York. So the United States more or less
wanted it in Pillar I, and the foreign countries did not; is
that it?
Mr. Hawke. No, the other way around. We wanted it in Pillar
II.
Mrs. Maloney of New York. You wanted it in Pillar II?
Mr. Hawke. That was one that we won.
Mrs. Maloney of New York. You won that one. Okay.
One of the things that I am concerned about, and this is
something that the ranking member mentioned and the chairman
mentioned, and everybody on the panel both sides have mentioned
our concern about how are we looking out for financial
institutions, American banks, to make sure they are not placed
at a competitive disadvantage? I would like to hear from all of
you. What are you doing to make sure that we are not placed at
competitive disadvantage? I can see a lot of things in this
that could hinder the competitive ability of our banks. So I
would want to know, do you have a formal procedure where you
make sure that we are not in any way hindering American banks
in the competitive market here or place unfair charges and
burdens on them?
Chairwoman Biggert. Briefly, please.
Mr. Hawke. Let me say that the very purpose of Basel II was
to try to improve competitive equality among internationally
active banks since it was felt that Basel I left too much room
for competitive inequalities to emerge. So in terms of
competition and competitive equity among internationally active
banks, that has been the name of the game. As I said, I think
that some issues, like the very complexity of the process
itself or the rule itself, work toward competitive inequity
because of the differences in the nature of the supervisory
systems between countries.
Mr. Ferguson. If I may address that issue as well, a couple
of things. One is, I believe that the strength of the U.S.
banking system deals with the fact that we have very strong
capital, among other things. If you compare the U.S. banking
system to that in Europe and certainly in Japan, I see no
competitive weakness at all in the U.S. by having strong
capital. I think just the opposite.
Second point, as my friend Jerry Hawke has pointed out, the
name of the game here and the reason to have these three
Pillars and to have transparency et cetera is to allow greater
competitive comparisons across institutions. That is one of the
reasons why we have entered into this, so as to reduce
competitive inequity.
The third is we clearly have in a number of places
decisions that a bank from wherever they may be operating in
the U.S. will be required to live by some of the elements of
the accord that we are developing here as part of national
discretion. So we have managed with this head-to-head
competition in some of these various portfolios to confront the
issue directly.
I think we should not make the mistake of believing that
having strong, well-capitalized banks with strong risk
management weakens them in a competitive sense, because the
recent history and long history indicates that the U.S. banking
system is extraordinarily competitive vis-a-vis many others who
have, frankly, exercised a lot more forbearance than we have.
So I think the strength of our system comes from just the kind
of regulation and the kinds of controls that we are discussing
here today.
Mrs. Maloney of New York. My time is up.
Chairwoman Biggert. Mr. Kennedy, the gentleman from
Minnesota.
Mr. Kennedy. Thank you, and thank you, panel, for your
testimony. I would just like to continue on that dialogue on
competitiveness. I will grant you that we have the world's best
banks and the world's best regulators, but when I look at that,
how do I make sure, and does Basel II make us more likely to
have uniformly applied regulations among the regulatory bodies
in other countries? You talk about this, how it gives you more
flexibility. Well, flexibility gives me concern if that means
that the other regulators in other countries do not apply the
same levels of standards that we do, that we put in that way
American banks at a competitive disadvantage.
Mr. Ferguson. I think there are three components to my
answer to your question. First, it goes back to the differences
between Pillar I and Pillar II, et cetera, where indeed Pillar
II is by definition one that creates more of a negotiation. It
is less transparent, and therefore there is more regulatory
discretion. Consequently, the need to put things such as
operational risk, I believe, in Pillar I where there is a more
rigorous framework, yes, built around internal management and
measurement approaches, but with a more rigorous framework and
more rigorous outline, point one.
Point two, is there are three Pillars here. One of them has
to do with transparency. One of the best ways I believe to
ensure the kind of international equality that you are
discussing is to have the banks that are under Basel II or will
be under Basel II required to disclose important parameters,
not the ones that are of competitive sensitivity per se, but
the ones that allow best comparisons across institutions in
terms of the nature of their portfolios, the nature of their
risk management capabilities so the counter-parties can look
and understand a bit more about them.
The third is that there is a structured process among the
members of Basel II, of the Basel Committee. There is an accord
implementation group that brings the regulators together to
hold each other accountable for how this is being implemented.
So that if we from the U.S. standpoint have a strong sense that
some of our colleagues around the world appear not to be
bringing the same focus, the same seriousness, we have this
infrastructure, this communication technique through the so-
called AIG, the Accord Implementation Group, that allows us to
pressure them and to encourage them to take the same approaches
that we are.
I think those three tools allow for a stronger sense of
competitive equity, and a real sense of checks and balances in
this process.
Mr. Hawke. I would endorse the points that Roger made, and
add one further point that continues to trouble me in the area
of competitive equity: that is, the vast differences in the
nature of supervision. As I said in my testimony, we have in
our largest national banks 30 or 40 full-time on-site
examiners. We are intimately involved with those banks. In
banks in some other countries, an outside auditor may do a
flyover once a year. There is a significant difference in the
invasiveness, if you will, of supervision between the United
States and other countries. Given that disparity, it is
inevitable, no matter how good the mechanisms are that the vice
chairman described, it is inevitable that there are going to be
disparities in application. The complexity of the proposal adds
to that potential.
Mr. Powell. I would just add one comment. We have been
talking a lot about the international anti-competitiveness. I
think it is important for us also to pause and think about the
domestic competitive inequities, if they are in fact are there.
That is the reason I think some of the issues that we will be
talking about as we go forward will come out in the public
comments. I, too, am concerned about regional banks and smaller
institutions that might be disadvantaged by Basel II.
Chairwoman Biggert. Thank you.
Mr. Kennedy. I would share that concern. I would just like
to follow up. Your discussions of the regional concerns are
shared with me when you have two different standards within the
same country. But following up on the international side, in my
years as chief financial officer, we would note significantly
different responsiveness from a Japanese-style bank versus an
American bank. One of my big concerns is the fact that the
hangover from that period where we had excessive bad loans in
the Asian countries that have not been written off; is this new
accord going to help bring our Asian counterparts towards
addressing those issues? Or do we have to look for other
avenues to try to encourage that?
Mr. Ferguson. I think that is again a serious question. One
would hope that if this is indeed enforced, and if again the
public disclosure part as well as the regulatory part forces
banks around the world, including Japanese banks, to use these
more sophisticated risk management techniques, that you will
find less of this irrational pricing that you have talked
about. One of the points that I have made often in discussions
is that the international banks, particularly the U.S. banks,
need not worry so much about strong regulation from the Fed or
the OCC or the FDIC, as they need to worry about irrational
pricing from competitors who do not have the same sophisticated
approach to risk management capabilities as embedded in Basel
II. So that hopefully would respond to some of your questions.
If I could take one minute to respond to the question about
domestic competitiveness, I think that is an issue that must be
explored in the comment period. However, as I have said in my
written testimony, there are a couple of reasons why I guess I
have a little less concern than my colleague from the FDIC, Mr.
Powell. The first is that smaller banks tend to have much more
information about their local counter-parties than a large
national bank that is not actively in that market. The large
national banks tend to depend much more on models and the
information that can run through models. We have not seen any
sense in which small banks are at a competitive disadvantage
today. They clearly have shown a great deal of strength because
of their understanding of local market conditions.
With respect to regional banks, the capital that matters is
not the regulatory capital which we are talking about here,
which is a minimum capital. It is economic capital. There is
nothing in Basel that is going to change economic capital. It
is going to make things more transparent, but not change the
economic capital that is the factor that decides pricing. In
places where economic capital, which by and large tends to be
higher than regulatory, that will certainly be the case. In
those few cases where economic capital is lower than regulatory
capital, which is to say you have new techniques that have
developed such as securitization, which clearly is an important
part of the U.S. market, that already exists. Both larger banks
and regional banks are both using these securitization
mechanisms to maintain a relatively level playing field where
regulatory capital was set too high and therefore there are new
techniques.
So I would argue even in the domestic situation, while it
is important to ask the question, as we will when we get into
the ANPR process, the proposed rulemaking process, I see
nothing here that immediately leads me to believe that the
competitive status quo is going to be changed domestically
because of these capital changes. There are a number of other
reasons that I have given in my written testimony to deal with
the competitive issue as well.
Chairwoman Biggert. The gentleman's time has expired. The
gentleman from Illinois, Mr. Emanuel is recognized for five
minutes.
Mr. Emanuel. Thank you very much. Thank you for coming
today.
Obviously, since the decade and a half since the first
Basel accord, it only makes sense to review, update and change
given how much the marketplace has changed, and given that the
first set of rules dealt with uniformity in the international
market and tried to bring some safe and sound banking rules
across borders and across markets. Although a lot of the
questions have dealt with international competitiveness for
American charter banks in the international market, I want to
deal a little or ask some questions as it relates to how some
of these rule changes have on a credit crunch. A lot of these
discussions, as our ranking member made sense, you do not get
questions like this about the Basel accord at town halls, which
is true. You do get questions from a lot of folks about the
notion that they cannot get access to capital at the very time
they need capital. Some of the capital requirements here that
have been discussed and recommended, my worry is they would
actually have an adverse affect at the time in which you need
capital, you cannot get it; at the time you do not need
capital, you have access to it.
So I would like to change just one; some of the rules and
some of the suggestions here, the 20 percent operational risk
capital charge, that also impact; it is also suggested that the
flexible system that results in banks holding more capital in
bad times and less capital in good times may adversely affect
the economy by decreasing credit availability when it is needed
most. I wanted to ask, as you go through the rulemaking
process, what are some of the potential unintended consequences
of new capital requirements as it relates to the flexibility
that you are going to now ask for in the system, as it relates
to the capital crunch in these times, whether the inverse
effect?
In any order, go ahead.
Mr. Ferguson. I will respond first, and I am sure my
colleagues will have other things to say as well.
Obviously, we have been aware of the concern about cyclical
implications with respect to Basel II. I have three or four
components to my response. First is, I believe and I think we
all collectively believe, that if you have a risk management
system that is more risk sensitive, then what it will allow is
for banks to make, and that sensitivity being measured over an
entire cycle; I will not go through the technical reasons, but
Basel II allows for that to be measured over an entire business
cycle, not just in a short term-what you will find is that loan
pricing is better. It reflects the risk. Therefore, what you
will find is you have less of a tendency to make unreasonable
loans during good times, and consequently are less surprised
when loans fall off and profitability falls off in bad times.
So there is a possibility that if you have much better risk
management techniques and that plays through to better pricing,
that you will get less of a cyclical swing, instead of more.
The other point I would make is that we, being quite aware
of some of these concerns, have also made a number of
refinements and adjustments to allow for some of the
measurements that the banks have to put in to again be less
focused on a point in time in the cycle, and instead extend it
out over a longer period of time. I will not try to go into all
the technical details here, but we have been aware of that and
have taken that on board.
I would also say that one of the important changes under
Basel II is that Basel I does not give banks credit for a
number of things that matter and help to offset risk, that we
plan to put into Basel II. For example, the current accord does
not give any capital credit when collateral or other methods
are taken to reduce risk and reduce the possibility of a loss
given default. So that should also work to mitigate the
possibility of having this be pro-cyclical. We will again
continue to look at this as one goes into the comment period. I
am aware of the comment, but I think the Basel Committee and
the staff that support it, having heard the comment, have
already undertaken two or three different efforts to reduce the
risk of pro-cyclicality.
The other point I would really have to make is indeed I
would think when times get bad, it is important for banks to
take that on board and to recognize, as they have during every
slow period, that it is appropriate to tighten credit to some
degree; not to create a credit crunch, but to tighten credit to
some degree. Most of the times when we have seen credit
crunches occur historically, it is because there is a sudden
and unexpected loss in profitability that has the risk of
eating into capital. If we have gotten this right, we will find
that you have fewer of those incidents occurring going forward.
So I am aware of the procyclicality argument, but I think
there have been a number of efforts made here to refine this,
to minimize that kind of risk, and indeed to make this, if you
will, a tool that allows good bankers to be better bankers
during both the good times and also the bad times.
Mr. Hawke. Let me just answer briefly, unless you had
another question. As a bank supervisor, not a central banker, I
get a little bit nervous talking about procyclicality in the
context of determining what the appropriate capital rules are
for banks. I think that the best thing we can do to avoid a
credit crunch is to make sure that our banks stay in
sufficiently healthy condition to be able to make creditworthy
loans when the opportunity arises, irrespective of what is
happening in the economy. I think once we get into the business
of trying to manipulate the capital rules to take account of
changes in the macroeconomy, we run the risk of subverting the
banking system to broader, perfectly legitimate concerns, but
with the potential for effects that we see in some other
countries where banking systems have been manipulated, where
banking systems have become a disaster and have not been able
to help in the recovery.
So this is an area that I think we have to approach with
great caution. As I say, my inclination as a bank supervisor is
to look at capital rules without getting too concerned about
procyclicality.
Mr. Powell. I would tend to agree with Comptroller Hawke. I
think the best defense against a credit crunch is a solid
banking system. You build up capital in good times so that you
can use it in bad times. I think there is a tendency for all
bankers during nad times to impose additional requirements when
we extend credit. But if in fact you have a healthy banking
system, there is always going to be available credit.
Chairwoman Biggert. The gentleman yields back. The
gentlelady from California, Ms. Lee.
Ms. Lee. Thank you, Madam Chair.
Let me first thank the witnesses for your testimony and
your presentations. I would like to ask all three of you just
to give us some feedback with regard to Basel II as it relates
to the real estate market. Some have said that it could
negatively and adversely affect the U.S. real estate market.
One, credit reallocations could adversely affect real estate
development. Secondly, higher capital charges could result,
well, would result in banks being forced to tighten their
lending requirements, which of course then means that loans to
anyone other than the highest rated would require banks to
increase their capital services. So if banks were forced to
retain more capital, it would be hard, I assume, to maintain
some banks' current lending activities, with certain customers
with lower credit ratings.
Finally, I think one of the problems that many are raising
with regard to the impact of Basel II on real estate
development is that there would be fewer resources to purchase
real estate loans from originators such as banks, leading to
the tightening of credit in real estate markets. I would just
like to get your feedback on those points, if in fact you see
that as a problem or if in fact there are ways that it really
is not a problem as you see it, with regard to Basel II.
Mr. Hawke. Let me take a crack at that. I think the Basel
Committee has been very sensitive to the potential for
inadvertent credit allocation as a result of what we are doing.
One of the problems with the existing Accord is that the risk
weight buckets that are used are so inexact in their
determinations of risk that they do create opportunities to
arbitrage the capital rules and that does have an effect on how
bank credit is allocated.
On real estate specifically, we have an ongoing dialogue at
present as to whether the approach to commercial real estate
lending is the right one. Commercial real estate lending is not
something that has been looked on in Washington with great
favor because it lay at the heart of many of the bank failures
in the late 1980s and early 1990s. The state of the art of
commercial real estate lending has changed quite significantly
since then. While there is an understandable skepticism and
concern about the inherent safety of commercial real estate
lending, we are inclined to think that we might not have to be
as tough on that as the experience of a decade or more ago
might suggest.
Mr. Ferguson. If I may respond to this as well, I think
that Jerry Hawke is absolutely right in suggesting that the way
to maintain healthy bank relationships in the context of real
estate lending is to create, again, a system in which they
really evaluate their risks appropriately and lend the right
amount at the right price. No country is benefited by having
excessive lending to any one sector, for sure. If Basel II
works well, or any new capital approach works well, then what
you will find is that indeed you have got a much better
allocation of capital and that is what we want.
Ms. Lee. But with customers with lower credit ratings?
Mr. Ferguson. That is the same issue. There is no different
answer there. We have benefited in this country from the use of
a number of new techniques that allow customers with lower
credit ratings that have still good assets to get loans from
banks. There is nothing that I see in Basel II that would put
that at risk. I would think Basel II would encourage better
pricing, for sure, which is again to everyone's benefit. There
are other rules that obviously should deal with disclosure and
transparency, et cetera. So I do not see any specific reason to
worry about customers with the lower rating in some sense not
getting the appropriate allocation at the appropriate price
with respect to capital from Basel II.
Mr. Frank. Will the gentlewoman yield?
Ms. Lee. Yes.
Mr. Frank. A brief question; one of the things that strikes
me, we have the three different agencies. Is the Fed the
controlling agency here regarding America's position, and is
that automatic because it is through Basel. If not, who decided
this? How did we get to the point where it is the impression it
has been the Fed's opinion that has governed. Why is that the
case and is that something that; how does that happen?
Mr. Hawke. Congressman Frank, I have been sitting on the
Basel Committee for four years, and I still do not understand
how decisions are made. They appear to--
Mr. Frank. Well, is it automatic because it is central
bankers? Did the president at some point designate a lead
agency? How does this happen?
Mr. Hawke. There are four U.S. agencies that participate:
the three of us and the Federal Reserve Bank of New York.
Mr. Frank. The Federal Reserve of New York is for these
purposes the equivalent of the national agencies?
Mr. Hawke. Yes.
Mr. Frank. That is kind of like giving the Ukraine two
votes, and Byelorussia votes at the United Nations, in 1945.
[Laughter]
Mr. Ferguson. Perhaps I should respond to this.
Mr. Hawke. I am not going to touch that one.
Mr. Ferguson. Congressman Frank, the way this works is
there are tough negotiations that occur among the three
agencies. The people at this table get into negotiation. The
people sitting behind us get into even more heated negotiations
to try to develop a U.S. perspective. There is no lead agency
here.
Mr. Frank. Okay. Suppose there is a division, does the
president ever decide?
Mr. Ferguson. No.
Mr. Frank. I have imposed on the committee's time, but this
is one of the procedural things I think we ought to be
straightening out. When we are talking about narrow technical
things, it is one thing, but it does seem to me we probably
ought to have some--
Mr. Ferguson. But there is no difference in this area, I
would argue, than in any other area of regulation. The OCC has
pointed out clearly that they have lead responsibility.
Mr. Frank. I differ with you, Mr. Ferguson, because each of
you is supreme in his area of which bank, that you have certain
basic things. But when we talk about an American negotiating
position with other nations, it does seem to me we ought to
have some more clarity as to who decides what that negotiating
position is. Right now, apparently we do not.
Mr. Ferguson. The Basel Committee has historically been a
committee that has brought regulators together to try to
determine what we think is the best approach to regulations.
Mr. Frank. Right, but it does seem to me we ought to have
somebody ready to make a decision.
Mr. Ferguson. Well, that is in part one of the reasons that
we negotiate, obviously, is to make sure that we can come to
you and give you our best advice. Clearly, one of the reasons
in a democracy is that you have a comment period when you do--
Mr. Frank. Yes, but you also have somebody who finally--
Mr. Ferguson. And we have this kind of discussions to do
that.
Mr. Frank. I think this is something the committee will
have to look into.
Chairwoman Biggert. The gentlelady's time has expired. Let
us do one more round. We do have another panel, but if we can
ask succinct questions and get succinct answers, we can do
another quick round. So I will start with a question.
There is the extensive comment period for this proposal and
for any rules that are coupled with several years of data
collection. Do you think that the time frame for implementation
of Basel II is a little unrealistic? It seems to me that the
time frame assumes that there will not be a need for a fourth
consultative paper. Is this a foregone conclusion?
Mr. Hawke. Not in my view, Madam Chairwoman. I think that
the domestic rulemaking proceeding that we are going to be
embarking on in the near future must be a fully credible and
reasoned process that has integrity to it. That means that if
we get comments back in that process from all sorts of
potential commenters who have not yet had a chance to swing in
on Basel, we have got to take them into account and evaluate
them. That means that if our collective judgment is that there
needs to be a fix, we have to either go back to Basel or let
our colleagues on the Basel Committee know that there is going
to be a U.S. exception on whatever the particular issue is.
Chairwoman Biggert. Thank you. Mr. Powell?
Mr. Powell. I agree with the Comptroller.
Chairwoman Biggert. Thank you for your short answer.
Mr. Ferguson. I agree as well.
Chairwoman Biggert. Dr. Ferguson?
Mr. Ferguson. I agree. You got two short answers in a row.
Chairwoman Biggert. The Federal Reserve recently issued a
white paper on infrastructure security in which it calls for
U.S. domestic financial institutions to increase expenditures
on infrastructure protection. This, coupled with the fact that
the Basel II proposal calls for a mandatory operational risk
charge troubles me. It seems like the Fed is requiring domestic
financial institutions to pay twice; once for improvements in
the infrastructure and once for a capital charge. Can you
explain for me why these seemingly divergent policies are
coming from the Fed?
Mr. Ferguson. I do not think they are all divergent. I
think they are actually quite consistent. Let me be pretty
clear about two things. One is there have been failures due to
operational risk. Secondly, the Fed as the lender of last
resort has had the largest single discount window loan ever
because of an operational failure. It was $20 billion. It
happened many years ago, but on a daily basis we have
institutions that because of operational failure borrow from us
during the course of the day. It is called a daylight
overdraft.
Thirdly, obviously as you well know, one of the recent
times I was here was post-September 11, in which we lent
several hundred billion dollars or over $100 billion. So we
take operational risk quite seriously.
Fourthly, there is nothing inconsistent about the two
activities that you just alluded to. The point of the white
paper is to encourage institutions to build appropriate backup
capability so they can be more resilient, and so the financial
markets can be more resilient. The point of Basel II is to say
because these things may occur even if you are resilient, it is
important to have capital. The way Basel II will work is that
if a bank has managed its operations so that it has reduced
some of the kinds of risks that we are concerned about under
Basel II and operational risk, then that will come into play
because the amount of capital they will be expected to hold
will be lower. There will be offsets, for example, for
insurance as well. So the two things I would say in lieu of
being contradictory are much more hand-in-glove. They are
really quite complementary.
Chairwoman Biggert. And you do not believe that there is a
pay twice?
Mr. Ferguson. No, I do not believe there is a pay twice.
Chairwoman Biggert. Okay. Ms. Maloney, do you have another
question?
Mrs. Maloney of New York. Yes, I have a short question for
Vice Chairman Ferguson. As you know, I have had a long interest
in the Fed's role in the payment system. Federal law requires
the Federal Reserve Board to calculate a private sector
adjustment factor, a PSAF, to ensure that it is not competing
at an undue advantage with private providers of payment
services. How will the Fed adjust the PSAF for the operational
risk capital charge banks will have to hold if the current
version of Basel II is imposed?
Mr. Ferguson. I cannot give you a specific answer. I can
tell you in general how we think about this. We have in our
system layers of backup that are similar to those that are
expected in the private sector. In fact, I would argue that we
have deeper backup than any private sector institution because
obviously we have 12 institutions around the country and we
work well together.
One of the issues that is considered in the PSAF, as you
know Congresswoman Maloney, is in fact questions of equity and
what the equivalent equity in capital would be in the private
sector. So obviously, we will consider that as we go forward.
But let me reiterate the point I made earlier. I do not expect
any bank to have an increase in the amount of capital being
held because of this operational risk charge. There may be
greater transparency. As Congressman Frank once said in another
context, it is really moving capital from one drawer to
another, from looking as though it is excess to being obviously
associated with operational risk. That does not mean that the
base of capital overall is going to go up, so I am not really
sure that since there will be I do not believe brand new
incremental capital in the banking system because of an
explicit charge for operational risk, that we should have to
change the PSAF. If that is the case, we will obviously adjust
the PSAF so we stay in compliance with the Monetary Control
Act.
Mrs. Maloney of New York. I would like to follow up with
Ranking Member Frank's question. Actually, I asked the same
question earlier. How do you resolve differences? If you get
back to us in writing. I have heard two descriptions of how you
resolve it, and I am still not clear, so possibly if you could
get back to us in writing.
Very briefly, Vice Chairman Ferguson, I want to ask the
same question actually I asked earlier. What is the necessity
for a minimum capital charge or Pillar I treatment for
operational risk, while you are not; why admit to interest rate
risk from Pillar I when it has really been the cause of more
bank failures, while subjecting operational risk to it. I do
not understand why they are treated differently when interest
rate risk is easier; there is a methodology that everyone
understands and there are more bank failures from it. Why is
that not getting Pillar I treatment?
Mr. Ferguson. One of the things you have to understand is
what the banks themselves do. banks themselves do operational
risk as very large. We have taken a survey and we found that
somewhere between 10 and as high as 15 percent of economic
capital, which is not this minimum, but the economic capital
that they hold, they often ascribe to operational risk. That is
a significant sign that the banks themselves see operational
risk as a real risk. We believe that implies and deserves
treatment as this credit risk in Pillars I, II and III.
The second point I would make is that banks actively manage
interest rate risk on a daily basis. There are large committees
called asset liability committees whose job it is to manage
interest rate risk. What we have found over history is that
they do a pretty good job of that. They are not perfect, and
the reason that we, the U.S., have taken a consistent point of
view that interest rate risk should be under Pillar II is that
we have found that our discussions with them about how they
manage interest rate risk under Pillar II has been quite
sufficient in keeping that appropriately under control, and the
banks understand that as well.
So this is an area where in some sense things have worked
reasonably well, and we believe that the status quo seems to be
the best approach. That is sort of the whole goal of these
various internal models, et cetera, that banks have. So I think
you should think of these two things as being slightly
different, and the approach to management being slightly
different. Frankly, the incentives that are required are also
slightly different, which is one of the ways I think op risk is
very much like credit risk and deserves treatment across all
three pillars.
Mrs. Maloney of New York. I want to clarify my position,
that I do not think that operational risk should be under
Pillar I, but I appreciate your, or interest rate, for that
matter. Would you like to; everyone has commented on it, would
you like to comment on it too, Mr. Powell?
Mr. Powell. The FDIC position is we are not concerned with
whether it is in Pillar I or II. We have no preference there.
Mrs. Maloney of New York. Okay. Thank you very much. My
time is up.
Chairwoman Biggert. Thank you. The gentleman from
Massachusetts is recognized for five minutes.
Mr. Frank. Mr. Powell, you just said that the FDIC has no
position on whether it should be Pillar I or Pillar II?
Mr. Powell. Right.
Mr. Frank. Mr. Hawke, does the comptroller of the currency
have a position on whether it should be Pillar I or Pillar II?
Mr. Hawke. As I said, we have argued until we are blue in
the face that it should be a Pillar II requirement.
Mr. Frank. Well, I am back to governance. Okay, I
appreciate that. Okay, we have got four; first of all, I have
to tell you, Mr. Ferguson, this is a profound issue for me. You
three are appointed by the President of the United States and
confirmed by the United States Senate. The New York Fed, as
capable a technical institution as it is, is, as are all the
regional banks, a self-perpetuating institution with no
democratic involvement in the appointment of the head.
Now, what we have is this, the four members; one prefers
Pillar II, one is indifferent, and we have a strong national
position in favor of Pillar I. I think the governance here is
awry. How did this happen?
Mr. Hawke. I would not say that we have a strong national
position in favor of Pillar I, Congressman Frank. The Basel
Committee as a whole has taken that position.
Mr. Frank. The Basel Committee of the United States?
Mr. Hawke. No, the Basel Committee in Basel.
Mr. Frank. Okay. But what about in the United States? I
certainly got the impression that the United States position
was strongly for Pillar I.
Mr. Ferguson. I think where we are on this is that we
believe, all of us, and I know Jerry will speak for himself,
but I think what I have heard him say is he has argued many
times for Pillar II. There was not a consensus. Pillar I with
this AMA approach seems to be a reasonable place to end up.
Mr. Frank. To whom?
Mr. Ferguson. I think to us.
Mr. Frank. Not to the FDIC, which is indifferent.
Mr. Ferguson. As I said congressman, Jerry will speak for
himself.
Mr. Frank. He just did. He said he argued.
Mr. Ferguson. Pillar I is a reasonable place to end up.
Mr. Frank. Look, it is okay to have a position, but I do
not think you are being totally straightforward about this. The
FDIC did not have a position on Pillar I or Pillar II. The OCC
was for Pillar II. And we wound up with Pillar I as a
consensus. This is some consensus. I would like the power to
impose such a consensus. I think clearly the Fed has become de
facto the lead agency, maybe because we are dealing with
international entities. I have to tell you, I think this
requires some further thought on our process. To the extent
that we are talking about fairly technical issues, that is one
thing. For instance, one of the examples we are dealing with
here; both my colleagues from California, Mr. Baca and Ms. Lee,
raised small bank-big bank issues. To be honest, I think most
people would rather have the FDIC and the OCC dealing with the
small bank big bank issue than the New York Fed as an equal. I
think these are legitimate governance issues that we have to
raise.
Nothing further for me. Mr. Ferguson, I will; oh yes, Mr.
Powell.
Mr. Powell. Congressman, I want to be sure that I am clear
with you. While we do not have a preference whether this should
be in Pillar I or Pillar II, we stress the need for supervisory
flexibility in the implementation of it.
Mr. Frank. I appreciate that, and I think that frankly goes
more for where we are, not where we were.
Mr. Powell. Right. I agree.
Mr. Frank. Yes, Mr. Hawke.
Mr. Hawke. I want to make clear that I support the AMA
approach, even though I would strongly prefer Pillar II.
Mr. Frank. I understand that. You are no longer blue in the
face, but you used to be, and I do think that goes to how we
got there.
Mr. Ferguson, just so that people do not think I am being
entirely anti-Fed, I will refrain from asking you what you
think about the President's tax plan. And I have no further
questions.
[Laughter]
Chairwoman Biggert. The gentleman yields back. This will
conclude the first panel. Thank you, gentlemen, so much for
coming, and your expertise.
The chair notes that some members may have additional
questions for this panel which they may wish to submit in
writing. Without objection, the hearing record will remain open
for 30 days for members to submit written questions to these
witnesses, and to place their responses in the record.
We will now proceed with the second panel. If they could
come forward and take their seats as quickly as possible,
please.
I would like to welcome the second panel First we have
Karen Shaw Petrou, the co-founder and managing partner of
Federal Financial Analytics, a privately held company that
specializes in information and consulting services for
financial institutions. Ms. Petrou spent nine years at Bank of
America as an officer in their San Francisco headquarters, and
then in Washington as the representative of the bank on Capitol
Hill, and before regulatory agencies prior to starting Federal
Financial Analytics.
Mr. Frank, did you want to introduce Mr. Spina?
Mr. Frank. Yes, I am very pleased that we are joined by
David Spina, who is the chairman and chief executive officer of
the State Street Corporation, which is Boston-based, actually
headquartered in the district of my colleague Mr. Lynch who has
joined us. He has been at State Street since 1969 and has had
obviously a variety of positions there. He became CEO in 2000
and chairman in 2001. I am impressed when I read the
information. I am impressed by two things, one that State
Street was cited by Working Woman magazine as one of the top 25
companies for executive women, but even more important that Mr.
Spina chose to put this in his biography. Frankly, he is a man
of many accomplishments, in a wide range of things. I would
note that he manages to expand two cultures. His undergraduate
is from Holy Cross and his M.B.A. from Harvard, so he has a
certain cross-cultural aspect. I do want to commend State
Street also for its ranking from Working Women magazine and for
singling it out, and for calling our attention for what seems
to me a very significant issue. Thank you, Madam Chair.
Chairwoman Biggert. Thank you. Next we have D. Wilson
Ervin, who is managing director of Credit Suisse First Boston
and head of risk management. He is a member of CSFB's risk
committee and the leadership and performance committee. He
joined CSFB in 1982 and has been involved in fixed income and
equity capital markets, the Australian investment banking team,
and the mergers and acquisitions group. Mr. Ervin received his
B.A. in economics from Princeton University.
Finally, we have Ms. Sarah Moore, executive vice president
and chief operations officer of the Colonial Bank Group. She is
a certified public accountant and worked for Coopers and
Lybrand for nine years prior to her career with Colonial. She
is a graduate of Auburn University with a B.S. in accounting.
Just so that Mr. Spina will not feel left out about his
college credentials, he has a B.S. degree from the College of
Holy Cross and an M.B.A. degree from Harvard University, and
was an officer in the United States Navy and served a tour of
duty in Vietnam.
We are pleased to have this panel. As with the prior panel,
if each of you could hold your comments to five minutes, and
then we will have questions following that, and we usually get
to any of the testimony that you did not get around to giving
when you gave your testimony.
Ms. Petrou, if you would proceed.
STATEMENT OF KAREN SHAW PETROU, EXECUTIVE DIRECTOR, FEDERAL
FINANCIAL ANALYTICS
Ms. Petrou. Thank you very much, Madam Chairman, and
members of the subcommittee. I appreciate very much the
opportunity to present the perspective of Federal Financial
Analytics on the capital rule.
My firm advises financial services firms with an array of
concerns on the Basel Accord. We also advise the Financial
Guardian Group, which is an organization of those banks
particularly concerned with the operational risk-based capital
sections in the accord.
I would like if I can to step back from the complexity of
the accord because so much has been done and the hard work on
this massive accord that Comptroller Hawke lately waved as
evidence of its depth and breadth. Economists have been
focusing very hard on how it will work and what its impact will
be and how these models may or may not be appropriate. I think
this is missing one fundamental lesson from decision theory,
which is you should maximize, do the best you can, not optimize
as it is put, letting in a sense the best drive out the good.
This decade-long effort since Basel I was put in place in 1988,
and was finally effective in 1992, we knew then that the rule
had some significant flaws. Mr. Frank has pointed to one of
those; the exemption from the capital framework of short-term
lines of credit. That was a compromise that was known early on
that that was in fact a very problematic one, because it
created artificial incentives to structure loans and credit
arrangements in a way to arbitrage the capital rules.
You have heard a lot from many institutions complaining and
asking questions about the Basel Accord, but I do not think
many have questioned the fact that Basel II would fix this
error, even though fixing it will cost them a good deal of
money. That is one of the things I would argue needs to be done
quickly. I think other things that are on the table on which
all of the regulators who were here before you in the first
panel agree can be done, should be done. Waiting for this
complex accord to grind its way to consensus and conclusion on
the 1,000 pages it has already hit and growing may delay
urgently needed action that would protect financial systems
here and abroad.
It is essential, I think, that this action take place and
take place quickly, because capital really does count. That
message also gets lost in those 1,000 pages, but capital does
count in the financial system in each of your districts. It is
the fundamental driver of how profitability is measured. So a
bank that has to hold more regulatory capital against a non-
bank is less profitable in that business on the whole as
another institution.
Economic capital is one of the ways the market says you
look risky to me; you need to hold more capital; we want the
shareholder putting up money before I as a debtholder or
another counter-party bank take a risk. It is very important
that regulatory and economic capital incentives align properly.
In fact, that is the objective which Basel II was originally
aimed at correcting; ending this regulatory arbitrage where
regulatory capital and economic capital differs. To the degree
that Basel II leaves these differences in place in areas like
operational risk, for example, new forms of regulatory
arbitrage will be created.
Similarly, to the degree that concern about rapid action to
address areas where capital should drop; mortgages, small
business loans for example, low-risk credit on which I think
most people have agreed on about at least what the right
initial risk-based capital rule ought to look like. You will
create different incentives for different lenders to be in
those businesses, to the degree that finally Basel II
recognizes the appropriate economic capital for low-risk assets
and drops it, the big banks using Basel II will get an
advantage over the smaller banks still left out of the system.
That could drive credit availability in the regions, as well as
the ability of local banks to structure products to meet local
needs.
This regulatory arbitrage issue is also apparent in some of
the smaller details of the capital rules. The issue of
commercial real estate has been mentioned. I would like to
bring up another area which is the treatment of small and
medium-size enterprises, SMEs in Basel talk. I like small
businesses a lot. I own one, but small businesses can be very
risky. The Basel rules define small and medium-size enterprises
as companies with annual revenues of $50 million; not the mom
and pop shops we are used to thinking about as small businesses
in this country.
The capital treatment for SMEs in the current version of
Basel II is considerably lower than what most of analysts think
is appropriate for economic risk. The reason is quite simple.
Last year, Chancellor Schroeder threatened to take the Germans
out of the Basel II negotiations unless the capital treatment
for SMEs was fixed in accordance with German demands. That is a
negotiating process. It is a legitimate one, but it is one
where I think the Basel II rules remain potentially flawed. It
is also an indication of the fact that this is a negotiation
where the United States can, and when it is necessary to
protect our interests, should intervene.
The operational area is one where I think that should take
place. We have had a very full discussion of that, and I know
David Spina will touch on that in his testimony. It is an area
where quick action on supervisory improvements is urgently
needed. Everybody agrees that we learned a lot very much the
hard way after the tragedy of September 11. On Tuesday, the
Basel Committee put out, rule two for operational risk
management. That now needs to be implemented, and implemented
in a meaningful way, not just in the United States, but in
Europe and Japan.
We here have many tools to require appropriate supervision.
I know Vice Chairman Ferguson cited some concerns that the U.S.
regulators cannot enforce safety and soundness requirements. As
a consultant in this field, I have never known them to be shy,
nor should they be. Congress has given U.S. regulators many
tools to enforce safety and soundness, and also to make the
capital requirements count. One immediate step Basel II should
look at is implementing comparable meaningful standards,
including linking penalties to capital noncompliance. At the
end of the day when the Basel II negotiations end, they will
come back here. U.S. banks will be subject to unique sanctions
if they fall below the sometimes arbitrary Pillar I thresholds.
In the EU and Japan, nothing happens, we have seen that, and
that is a central and immediate thing which Basel II needs to
address.
The small bank issue is one I have mentioned briefly. There
are some potential and significant issues there that need to be
addressed and there can be rapid action on the agreed parts and
sections of Basel II. Finally, the non-bank issue is an
extremely important one, especially in the area of operational
risk, where the banks that will be particularly adversely
affected by operational risk-based capital, an arbitrary Pillar
I charge, compete head-on with non-banks in the asset
management and payments processing area.
Chairwoman Biggert. If you could wrap up, please.
Ms. Petrou. Excess capital is not that when it is put into
the regulatory framework where these penalties would apply. It
is very important that those capital determinations be made by
the market.
Thank you.
[The prepared statement of Karen Shaw Petrou can be found
on page 133 in the appendix.]
Chairwoman Biggert. Thank you very much.
Mr. Spina?
STATEMENT OF DAVID SPINA, CHAIRMAN AND CHIEF EXECUTIVE OFFICER,
STATE STREET CORPORATION
Mr. Spina. Madam Chair, members of the subcommittee, thank
you for this opportunity to testify today and, in absentia, I
would like to thank Representative Frank for his introduction
earlier. Let the record show that my mother could not have done
a better job. It was very nice of him to be so gracious.
I am chairman and CEO of State Street Corporation, a global
financial services company chartered as a bank in 1792 in
Boston Massachusetts. We provide services such as custody and
safekeeping for investment securities, fund accounting for
investment portfolios, and investment management for public and
private institutions such as pension plans, mutual funds,
endowments and the like.
We believe the current Basel proposals will have
significant negative competitive effects on U.S. banks, and if
offered the option, we would choose not to opt into the new
Basel operational risk capital framework. However, due to our
significant position in our industry sector and the
international nature of our business, we expect to be required
by U.S. bank regulators to comply with Basel II.
Before I summarize our objections, I would make clear that
we agree with the Basel Committee that operational risk is a
critical risk issue. We view the U.S. bank supervisory system
as among the best in the world, which is an asset to U.S.
banks. The strength of U.S. regulation, however, also creates
challenges as we compete with institutions subject to less
intensive regulatory supervision abroad. The U.S. supervisory
approach to operational risk today is already working. It is
treated as a Pillar II matter under Basel-speak today, and we
believe that this provides a strong foundation for even better
risk management practices going forward.
The Basel Committee proposal would impose a new capital
framework or requirements on banks based on statistical
measures of operational risk. Using the Basel terminology,
operational risk would fall under Pillar I, which establishes
capital standards, as opposed to Pillar II, which addresses
risks through supervision. The Basel definition of operational
risk is a very, very broad definition, including nearly all
risks inherent to conducting a business.
Let me explain State Street's experience with operational
risk. In the over 200-plus years that we have been in business,
we have learned that relying on a capital cushion to absorb
losses is a crutch, not a solution. Our focus is on rigorous
risk management with a goal of reducing errors and avoiding
losses. We minimize operational losses by making ongoing
investments in systems, people and business continuity
planning, and by ensuring our contractual arrangements clearly
allocate risk between State Street and our clients. Our long-
documented history of very low operational losses tells us that
this approach works.
Operational risk, of course, is part of doing business for
any company, but it is really an issue of earnings at risk,
rather than capital at risk. In the very few highly publicized
bank failures often attributed to catastrophic operational
losses, no reasonable level of capital would have prevented
bank failure. Adding a new regulatory capital requirement for
operational risk will have a detrimental effect by creating
disincentives for effective risk management and by creating an
uneven competitive playing field for U.S. banks.
Let me make four points very quickly. The Basel Committee's
proposal creates a perverse incentive for banks to
disproportionately focus financial and management resources
towards meeting capital requirements, rather than on making
essential investments in systems, people and business
continuity planning. This is a little bit of the paying twice
issue that Representative Maloney was referring to earlier.
Second, the Basel Committee's proposal would disadvantage
banks competing with non-banks. In the U.S., non-bank
investment managers, fund accountants, payments processors and
broker dealers are not subject to the current bank capital
rules, nor will they be subject to the new capital requirements
for operational risk. These non-banks include financial
services firms that are well known; Firms like Fidelity
Investments, our neighbor in Boston, SunGard, Merrill Lynch,
and numerous others whose names you would recognize. The result
under the Basel proposal is an unfair competitive disadvantage
for banks competing with these non-bank financial firms.
Third, the Basel Committee's operational risk proposal will
hurt U.S. banks in the international marketplace. The
proposal's untested quantification methods create a high
probability of inaccurate capital assessments. Such errors
disadvantage U.S. banks, which face far quicker regulatory
response when we step over a regulatory line than we believe
our competitors face in other countries. For example, U.S.
banks are subject to the prompt corrective action required
under FDICIA. It is prompt and it simply does not exist
elsewhere in the world. In short, Basel creates a high risk of
uneven application and enforcement, I think to the detriment of
U.S. banks.
Finally, the banks that are most negatively impacted by the
Basel Committee's proposed treatment of operational risk are
what people often call trust banks; banks that specialize
primarily in holding individuals' and institutions' assets as a
custodian, fiduciary or investment manager. Disproportionately
penalizing such banks with a new capital requirement could
discourage competition and participation in such business
lines, to the ultimate detriment of all investors.
In summing up, I urge the subcommittee and the U.S.
regulators to consider the potential detrimental effects of the
operational risk proposal on U.S. banks, and instead to insist
on the adoption of a rigorous supervisory approach under Pillar
II of the proposed Basel framework.
Let me just simply say thank you and stop there. I look
forward to your questions.
[The prepared statement of David Spina can be found on page
160 in the appendix.]
Chairwoman Biggert. Thank you very much, Mr. Spina.
Mr. Ervin?
STATEMENT OF D. WILSON ERVIN, MANAGING DIRECTOR AND HEAD OF
STRATEGIC RISK MANAGEMENT, CREDIT SUISSE FIRST BOSTON
Mr. Ervin. Thank you. Good afternoon, it is an honor to be
here. My name is Wilson Ervin. I am presenting testimony today
on behalf of Credit Suisse First Boston, and on behalf of our
trade group, the Financial Services Roundtable.
CSFB is a major participant in global capital markets,
employing approximately 22,000 people. We are headquartered in
New York and regulated as a U.S. broker dealer and a U.S.
financial holding company. CSFB is also regulated as a Swiss
bank and will be required to use Basel II. Our implementation
will be governed primarily by the Swiss EBK, but also by other
regulators including the Federal Reserve and the UK FSA.
As head of CSFB's risk management functions, my job is to
assess the risks of our bank and protect our capital. That is a
goal similar to many of the goals of bank supervisors. We agree
with the importance of bringing the current regime up to date
and fully support the objectives of Basel II. I personally
developed tremendous respect for the regulators who have worked
on Basel II, many of whom have been in the room today. They
have addressed a great many challenging issues with stamina and
sophistication, and they have been tenacious in trying to get
to a best practice solution in each one.
Yet while there is much to admire in the new rules, there
are also many elements that raise serious concerns. We hope
this committee, in conjunction with regulators and banks, will
use this opportunity to improve the current proposal so that
Basel II can live up to its original and very worthy goals.
Today, I would like to focus on four macro issues that
Chairman Oxley mentioned earlier. They are, number one, cost,
complexity and adaptability over time; number two, pro-
cyclicality or the risks that the new accord could actually
deepen economic recessions; number three, operational risk; and
number four, disclosure requirements.
The first topic I would like to address is the high cost
and complexity of the new rules and the effect this will have
on whether the rules remain relevant over time. Most of this
complexity can be found in Pillar I, which describes the recipe
for calculating capital requirements. This is more than 400
pages, as you saw earlier today, and more than 12 times the
length of the original Basel Accord. It is a normal result from
this kind of process. Once you start trying to boil down the
complexity of the real world into a series of mathematical
formulas, it is very hard to stop halfway. I am concerned that
this very complexity will make the rules difficult to update
over time, and potentially lock us into that ``early-2000''
mindset regardless of what the future looks like.
An example of this complexity is the proposal for
securitization, which is a common method for financing housing
and credit cards. The draft proposal in this area alone runs to
40 pages and contains daunting formulas, as you can see from
the examples submitted in annex one of my written testimony.
The cost of implementation will be high. We estimate that
approximately $70 million to $100 million in startup costs for
our firm will be spent, even though we already use fairly
sophisticated techniques for measuring economic capital on an
internal basis. When these costs are multiplied by the
thousands of banks within the global banking system, this will
amount to billions of dollars in additional costs. Some of
these costs will be passed on to consumers and corporations,
and some of these costs may force banks to exit certain
activities and leave those markets to unregulated entities.
Procyclicality: the new rules will change how banks
calculate their capital and the amount of business they choose
to do. We have analyzed the impact of applying the Basel II
rules to loan portfolios over the last 20 years of credit
cycles. Our calculations indicate the new rules require much
more bank capital during economic recessions when compared to
the current system. As an example, let's think about the last
few years. This period has seen a large number of corporate
downgrades in a sluggish economy. Unlike the current accord,
the proposed system will require significantly more capital in
that environment. Under those circumstances, banks will have to
choose between raising more capital or cutting the amount of
lending they do.
My personal estimate is that our bank would have cut back
our lending by perhaps 20 percent if the Basel II rules were in
place last year. If all banks cut back on lending at the same
time, as they will tend to do under a common global regulatory
regime, the potential adverse impact on the real economy could
act to lengthen and deepen economic recession. While it is
difficult to estimate the size of this effect, I would submit
that herd behavior can make small problems into big ones.
In addition to credit risk reforms, Basel II also focuses
on operational risk; the risk of breakdown in systems and
people. While a more refined scientific approach to credit risk
has considerable merit, the proposed quantification of
operational risk is highly problematic, in my view. It would be
great to quantify and control all risks with statistical
methods, but there are fundamental reasons why this would be
difficult to do with operational risk in practice. You have
mentioned legal risks several times, and I think that is a
particularly tough nut to crack.
Can you really calculate the maximum loss a bank would
suffer from that, or from potential fraud, an IT breakdown or a
major disaster? How do you estimate how likely those events
are? I have yet to see anything substantial that suggests that
operational risk really is measurable in a way that is similar
to market and credit risk. In fact, I think we may be creating
a real danger, a false sense of security that we have measured
operational risks and therefore controlled them.
One of the strengths of the proposals is they go beyond
capital calculations and also look to improve market
transparency. While we support the concept behind the proposed
rules here in Pillar 2I, the detailed proposals are cause for
concern. We currently publish about 20 pages of detailed
disclosure about risk in our annual report. We estimate that
Pillar 2I would add another 20 to 30 pages of much more
technical data to that total, but provide little of value to
the reader. Indeed, few people in my experience are able to
digest all of the information already presented on risk, and
now this information would bury them in a deeper, more
technical pile of data. While we support transparency, we
believe the current proposals are more likely to confuse than
to illuminate.
In sum, we believe the Basel effort is a worthy goal, and
we have a high regard for the efforts of the regulators who
have worked very hard to build it. CSFB and the Financial
Roundtable have also worked hard to contribute to that
discussion in a constructive and open manner. Simplifying the
complex rules currently found in Pillar I will require strong
discipline in the next round of drafting, and return to some of
the original philosophy of the project. I believe that much can
be accomplished if we increase the emphasis on principles,
rather than formulae in Pillar I, and if we increase the weight
of Pillar II.
Pillars II and III have real people on the other side--
regulators and the market. Real people can adapt to changes and
new markets much more easily than a rule book can. This puts
the burden back where it belongs, on the shoulders of bank
management to demonstrate to the regulators, to you and to the
public that we are doing a good job. That is in the spirit of
the Sarbanes-Oxley reforms, and I think it is a smart and
durable way to improve discipline.
Thank you very much.
[The prepared statement of D. Wilson Ervin can be found on
page 58 in the appendix.]
Chairwoman Biggert. Thank you very much, Mr. Ervin.
Ms. Moore?
SARAH MOORE, CHIEF OPERATING OFFICER, THE COLONIAL BANK GROUP,
INC.
Ms. Moore. It is a pleasure, Madam Chair, to appear before
the subcommittee to present our concerns on the revised Basel
capital accord. I am Sarah Moore, executive vice president and
chief operations officer of Colonial Banc Group, which owns
Colonial Bank, a $16 billion bank operating in the southeast,
Texas and Nevada.
We anticipate the impact of the new accord will be far-
reaching, as it will affect not just the largest banks, but
rather its effects will be felt by banks of all sizes.
Moreover, it will have a measurable effect on the nation's
economy. The revised Basel capital accord is an extremely
complex document. We believe Basel II has the unintended
consequence of giving the largest U.S. banks an unwarranted
competitive advantage over smaller institutions that compete
against them, and importantly, places all U.S. banks at a
competitive disadvantage to non-banks and to foreign banks.
We share the concerns about operations risk, but the most
problematic issue in the accord for Colonial Bank and other
regional banks is the proposed treatment of commercial real
estate. We further believe that as drafted Basel II will lead
to a loss of credit opportunities in the real estate sector
since the accord treats lending to this area in an unreasonably
disparate manner. Proponents of this new accord have argued
that the accord will reduce the capital requirements for
certain banks. However, with respect to real estate lending, no
bank is able to utilize the tools under the accord for this
purpose.
While all other types of lending can utilize tools
envisioned in the accord, real estate lending is set on a
different shelf. Commercial real estate lending is identified
in the accord as a more volatile high-risk type of lending than
every other type of lending. banks that use risk assessment
tools to measure performance of their real estate portfolios
cannot, regardless of the performance of those portfolios, gain
entitlement to lower capital standards, as the accord allows
them to do with respect to every other type of lending.
As a result of this arbitrary characterization of real
estate lending and despite the hundreds of millions of dollars
that will be spent in developing models and tools needed to
comply with the accord, banks will be unable to adjust their
capital levels to reflect the actual risk levels posed by real
estate lending as determined by the tools themselves.
Why did the Basel Committee use net charge-offs for all
U.S. banks to develop risk-based capital allocations? I'll tell
you. The numbers do not support the capital treatment provided
under the new accord. This is made quite clear in the graph
which we have attached to my written testimony. This graph
illustrates net charge-offs by loan type for all commercial
banks from 1985 through the third quarter of 2002. You can see
from the data, since 1995, right in this area, that commercial
real estate loans have had lower net charge-offs than consumer
loans and C&I loans. Yet under the accord, banks must carry
higher levels of capital for commercial real estate loans than
all other types of loans.
Let's walk through an example of how a commercial real
estate loan is treated in the proposed accord, versus an
unsecured loan to WorldCom. Assuming we have a $100,000 loan
collateralized by a fully-leased office building, the borrower
has performed as agreed, with a good repayment history, this
loan would carry a capital charge of $8,000. By contrast, a
$100,000 unsecured loan to WorldCom, which had a Moody's credit
rating of A2 prior to WorldCom's announcement of accounting
irregularities, would have carried a capital charge of only
$1,600. Which one do you perceive as higher risk: a loan
collateralized by real estate, which you can touch and re-sell,
or a promise to pay from a telecommunications company? While
the accord is intended to strengthen banks, in this instance it
encourages making unsecured loans, rather than secured ones.
The proposed accord also would create an uneven playing
field as a result of the lending patterns of the largest banks
in the country compared to regional and community banks. The
level of commercial real estate loans, as a percent of total
loans, is twice as high for banks under $15 billion as it is
for banks over $200 billion. In the southeast, non-mammoth
banks carry an even greater load. Thus, an automatic and harsh
treatment of commercial real estate disadvantages smaller
institutions far more than larger ones.
The inherent flaws in the accord would benefit only a
handful of the largest U.S. banks, while the majority of
community and regional banks would be burdened by higher
capital requirements and increased expenses. Moreover, the
disparate treatment of commercial real estate lending will
manifest itself through significant credit crunches and dismal
economic performance.
With that in mind, we urge the Congress to require that
prior to any action on an international agreement on capital
standards, the federal banking agencies, in consultation with
the Secretary of Treasury, evaluate the impact of such a
proposed agreement, take into account a number of factors such
as the impact of the proposal on small and medium-size
financial institutions, the real estate markets, and other
factors, and then submit a report to Congress.
I thank the subcommittee for allowing me to be heard today.
[The prepared statement of Sarah Moore can be found on page
120 in the appendix.]
Chairwoman Biggert. Thank you very much. I appreciate your
testimony. Once again, we will have a round of questions at
five minutes each, so please keep your questions short and your
answers, and we will have more times for questions.
I will recognize myself for five minutes. Ms. Petrou, which
countries win and which countries lose as a result of Basel II?
Are France and Germany and the United Kingdom going to be
treated equally with the United States under the proposed new
accord? You mentioned in your testimony that Germany threatened
to leave the negotiations if they did not obtain favorable
treatment for small and medium-size enterprises? How common are
these tactics?
Ms. Petrou. This is a negotiation. The rules will apply
equally to all parties in the Basel accord; the United States,
UK, Germany, France, Japan and so forth. The real question is
once each home country's regulator opens the rulebook, how will
they interpret it and how will they enforce it.
Chairwoman Biggert. Thank you. Mr. Ervin, your bank seems
to be in a unique position of having regulation by both the
United States and Switzerland?
Mr. Ervin. As well as the UK and I believe approximately
100 other regulators around the world.
Chairwoman Biggert. So you have many host countries to be
under regulation. Do you think that there is going to be; how
will that work?
Mr. Ervin. We are concerned. We have not seen how it will
work yet. We already have tension, where occasionally one
regulator will advise us to do one thing, and another regulator
will request something different, and we need to comply with
both. Sometimes that is very difficult in practice. That is a
catch-22 situation. To date, that has been reasonably easy for
us to manage, working cooperatively with regulators in the UK,
Switzerland and here, which are our primary regulators. But the
Basel accord is much more complex. It goes much deeper. I think
you are going to have much more serious home-and-host problems
going forward. The costs that we have talked about here will
multiply very dramatically if we have to maintain multiple
systems to satisfy the needs of multiple regulators.
Chairwoman Biggert. Do you see that with this new complex
structure as potentially having an adverse impact then on
global trade in financial services? Will this drive further
divisions in an already sensitive area?
Mr. Ervin. I think you will see some significant changes in
trade in financial services. I think this accord is enough of a
``big bang'' so that we do not know all of them yet. I am not
smart enough to predict exactly which changes will happen. I do
think there will be some incentives that potentially increase
consolidation in some areas, some places where it will affect
banks differently in different countries, and also some areas
where institutions have to become non-banks to compete
effectively. I think you will see a lot of changes in trade, I
am just not sure what they will be exactly.
Chairwoman Biggert. Thank you. Ms. Moore, what interaction
has Colonial Banc Group had with the Federal Reserve and the
other regulators during the negotiations surrounding Basel II?
Has your input been solicited by the Fed?
Ms. Moore. It depends on which Fed you are talking with.
The Federal Reserve Bank in Atlanta has solicited our comments,
they met with us, they told us to get ready to begin to comply
with the accord, which is contrary to what Vice Chairman
Ferguson testified to this morning, that it will apply to only
the 10 largest banks, and yet the Federal Reserve has told us
that we need to get ready; that the expectation is that we
should comply with the accord. We have had really no input into
the process. I don't believe our voices were heard, it stopped
at the Atlanta Fed.
Chairwoman Biggert. I thought that as a regional bank that
you would perhaps decide to be in it, or decide not to, but
this sounds like it is more you might be told that you are in
it.
Ms. Moore. The Federal Reserve told us that they expect us
to begin compliance with the accord. We also believe that the
market forces will dictate that we comply. We are a publicly
traded company. We have 124 million shares of stock
outstanding. We feel like the market will force us to
compliance, or we will be viewed as unsophisticated. Of course,
we are very concerned because of the competitive disadvantages
that we believe this will create on a regional bank our size.
Chairwoman Biggert. If this were so, or even if you did
decide, if that was changed, could you be prepared by January
1, 2007?
Ms. Moore. No.
Chairwoman Biggert. Have any resources been directed to the
effort?
Ms. Moore. A whole industry has developed around providing
banks resources to help them comply with Basel. We have
consultants calling us each and every day; we can help you; we
can help you; buy this software; we will help. We do not have
the internal resources. We are busy trying to run a $16 billion
bank every day. I am the chief operations officer. We have a
lot of technology projects that are trying to keep us
competitive. This will divert resources away from things that
will make us more profitable and make us a stronger financial
institution, no doubt about it.
Chairwoman Biggert. Do you have any idea what this could
cost your institution to implement Basel II?
Ms. Moore. It will be tens of millions of dollars, not
counting the internal man hours associated with Basel II.
Chairwoman Biggert. Thank you very much.
The gentlewoman from New York?
Mrs. Maloney of New York. I defer to the ranking member.
Mr. Frank. I thank the gentlewoman, because I am going to
have to leave after this.
I would ask particularly the two bank representatives, Mr.
Ervin and Mr. Spina, I remember asking Mr. Ferguson why
publicity was enough, because he acknowledged that transparency
would be the same in either case. His answer to me was, better
they should go with Pillar I with their ability to impose a
capital requirement, than to engage in Pillar II because in
that case they may have to say rude things about you, and that
would undermine the cooperative relationship. My question then
is, from your standpoint, would you think it would be better to
have Pillar I, which would have this I think somewhat rigid
requirement, would you trade that for Pillar II with the
possibility that that might lead them occasionally to make
public comments about you? It seemed to me that he had it
reversed in what I would want if I were involved, and I
wondered if you would both address. Mr. Spina, why don't we
start with you?
Mr. Spina. I think that in one sense we would all want
simple rules, but what we are dealing here in capital
allocation and capital adequacy for a bank is complex. If you
imagine a dialogue with a regulator and the Federal Reserve is
our principal regulator at the bank level, because we are a
state-chartered bank--if they have a Pillar I rule, then they
start with the high ground, the authoritarian position. They
have the weight of everything behind them, so we do not have
any wiggle room. I am not saying that we should, in some cases.
Pillar II, does allow for more dialogue Back and forth, but
at the end of the day it is still the Federal Reserve, that is
the decision-maker and they can still pull the rug on us and
issue a cease and desist order or something like that. The
question is whether they start the dialogue with all the
authority behind them, or whether they finish it. I would much
rather have it under Pillar II.
Mr. Frank. Mr. Ervin?
Mr. Ervin. I would agree with that. Like State Street, we
pay attention when the Fed talks. That is regardless of whether
it is Pillar I or Pillar II. Either one would be public. If
your Pillar I calculations fall below a level, that is as
public as if you were in a ``name-and-shame'' situation under
Pillar II. Our point has mostly been that the mathematics and
the modeling capability fits in Pillar I, and to my mind
operational risk modeling really does not seem to be built on
solid foundations.
Mr. Frank. I appreciate that. It did seem to me, as Mr.
Ferguson explained, he said basically they wanted to stick with
Pillar I rather than Pillar II because if they did it under
Pillar II, they might reach the point where it almost sounded
like it was Pillar I, so they start out with Pillar I. That is,
they got to that point and I was not persuaded by that.
Let me also ask, again this is new to us, but in some ways
it seems to me the capital charge may be almost irrelevant to
the evils they say they are trying to ward off; we have got
ING, baring and some of the other, the Allied Irish Bank; would
the level of capital charge we are talking about have been of
any use, Ms. Petrou, in the situation of those, if there had
been a capital charge, would that have helped greatly?
Mr. Spina. I do not believe that it would have been
sufficient to cover the losses in those cases.
Mr. Frank. Ms. Petrou?
Ms. Petrou. No, I would certainly concur with that. I noted
in Chairman Powell's testimony he talked about operational risk
as the cause of many recent bank failures, and then he points
out correctly that those operational risks were internal fraud,
for example in Keystone. This committee had many hearings on
the failure of Keystone National Bank, and you will recall that
that internal fraud was in part inside chief executive officers
burying piles of paper on assets they had said they had sold,
they did not sell them, and they buried all the paper in their
own backyard.
I do not know what an operational risk-based capital charge
would have done. To expect that on the one hand the risk
managers would be calculating some form of measurement charge
with the possibility upstairs, and then--
Mr. Frank. I appreciate that, but again there is obviously
the analogy here to the capital that you need for lending risk,
but it does seem to me with lending risk you are much more in a
more or less situation that you may miscalculate. Whereas with
this kind of risk, it seems to me more likely to be an either-
or than a more-or-less, and it does seem to me that the capital
charge and the level of a capital charge is more suited to the
former. Is that a reasonable view, Mr. Ervin?
Mr. Ervin. I think that is a very reasonable view. It goes
to the fundamental difference between the two. In market and
credit risk, you take those risks specifically for the prospect
of gain. It is part of your business. It's different with
operational risk, nobody wants more fraud risk or more legal
risk. You try and stamp that out as soon as you can find it. So
that makes it a fundamentally different animal. I think that is
one of the core reasons why it is hard to put under Pillar I.
Mr. Frank. Yes, it does seem to me that more-or-less and
either-or are different conceptual frameworks, and that we
ought to do that. I assume we would agree that there ought to
be very serious supervision here about management risk.
Chairwoman Biggert. The gentleman's time has expired. The
gentlewoman from New York?
Mrs. Maloney of New York. Clearly, I think we need more
hearings on this, and I am glad that the ranking member had
called for this initial hearing, and I hope that he calls for
more, because I think some very serious issues have been raised
when three executives from American business and international
business point out the flaws in this and the ways that they
perceive it will really hurt their ability to provide services
to our constituents, to consumers.
I would really like Ms. Petrou to respond to the rather
startling example that Ms. Moore gave, where the credit risk of
buying WorldCom under the Basel accord, according to her
example, would have been perceived a higher capital standard
for the real estate than for WorldCom. Isn't the whole point of
Basel to make the capital risk relationship more true to
reality? The example she gave was exactly the reverse. So I
would like to hear your comment on it.
I feel that one of our roles in government is oversight. I
am very concerned about any competitive disadvantage. If the
bankers could just in your closing remarks go over what you
think. We certainly do not in this country want to do anything
that makes it harder for the American business, American
financial banks to operate, because then that has a negative
impact on people, on our consumers, on our constituents. I
would like you to comment on the real life, real world
consequences that this will have on your profitability, your
products, and the impact on your constituents. But Ms. Petrou,
could you please comment on the; I found her example
startling--could you comment on that please?
Ms. Petrou. Yes, ma'am. It is. It is an example of the many
problems I think that are buried in those thousand pages. When
people sit down and start to run them, there are startling
results. This is in part because the treatment of credit risk
mitigation is still very incomplete. I would argue it is one of
the things that Basel ought to be doing quickly; collateral,
certain forms of loan insurance. There are numerous ways we
have learned over the years to put somebody in the middle
between a lender and loss. There is a lot that could be done to
fix that, but I am not convinced the current version does.
Mrs. Maloney of New York. I want to thank Mr. Oxley for
calling for these hearings, and of course my colleague, Ms.
Biggert, with whom we work on so many issues. Could you comment
on the competitive disadvantage that all of you have testified,
and also whether or not the Fed or the OCC has responded to
your concerns when you have raised them.
Mr. Spina. From State Street's perspective, we compete in
much of our products and services with non-banks. Accounting
firms and data processing firms can offer similar services. We
do offer bank-related services, which is why we keep our bank
charter as well. But clearly, if we had a capital charge, that
would impose a cost on the company. We would have to earn a
return on that capital and our competitors would not be
burdened with that cost. So I think it would be a material
event in the sense that it would force us to reexamine our
business model entirely and see how we provide those services.
In terms of dialogue, we are uniquely focused in this kind
of business, and we have benefited from a lot of dialogue and
access to the Federal Reserve. I give them very high marks on
that. The Boston Federal Reserve, the New York Federal Reserve
and the Board of Governors have sponsored meetings both at
State Street and in Washington and in New York. We have made
our points, but we do not seem to come to closure, which is
really why we are here. They hold their position that they
think operational risk needs to be Pillar I, notwithstanding
the arguments.
I have seen them bend in other related situations on
different aspects of the credit risk proposal, after dialogue,
and the proposals have gotten better, and this whole advanced
management approach is a lot better than where we started a
couple of years ago. However, we still cannot get them all the
way to Pillar II, which is where we are focused.
Chairwoman Biggert. I hate to break in here, but we have
just a few minutes because of the timing of the room. So Mr.
Ervin, if you could just in a couple of sentences, and Ms.
Moore, we will have to complete our hearing.
Mr. Ervin. I would support Mr. Spina's comments. I think
that some of the biggest differentials are going to be between
banks and non-banks. We compete very heavily with non-banks in
many of our lines of business. I am worried that we will become
less competitive and potentially will have to cede some of
those lines of business to non-banks going forward.
With respect to national implementation, as I said before,
we see a lot of differences in different countries. I would
tell you that you do not need to worry about Switzerland. They
are one of the toughest regulators out there. They are very
proud of their banking tradition, and are very strict. But I
think there is a risk that the stricter regimes, such as
Switzerland or the U.S. regime or the UK regime, could be
disadvantaged versus other countries.
Ms. Moore. I like the idea of more hearings. It is an
excellent idea. I feel like the industry, especially banks of
our size, are just now getting up to speed on the impact of
Basel. When the regulators are telling you, and making public
statements, that only Basel will apply to the top 10 banks;
banks are thinking, great, I don't have to worry about that
600-page complex document, when in reality they should be
worried about it. I believe these hearings will raise the
awareness of the banking industry and get more people like
Colonial Bank involved in the process. Thank you.
Chairwoman Biggert. Thank you. The chair notes that some
members may have additional questions for this panel which they
may wish to submit in writing. Without objection, the hearing
record will remain open for 30 days for members to submit
written questions to these witnesses and to place their
responses in the record.
Thank you all very much. You have been an excellent panel,
and thank you for sitting and waiting through the other panel.
We really appreciate it. I wish we had more time, but maybe you
will be back. Thank you very much.
The hearing is adjourned.
[Whereupon, at 12:57 p.m., the subcommittee was adjourned.]
A P P E N D I X
February 27, 2003
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