[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
THE NEW BASEL ACCORD:
PRIVATE SECTOR PERSPECTIVES
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
FINANCIAL INSTITUTIONS AND CONSUMER CREDIT
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
JUNE 22, 2004
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-96
U.S. GOVERNMENT PRINTING OFFICE
96-292 WASHINGTON : 2004
____________________________________________________________________________
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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 Chair JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York
JIM RYUN, Kansas BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
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 FOSSELLA, 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 CHRIS BELL, Texas
TIM MURPHY, Pennsylvania
GINNY BROWN-WAITE, Florida BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Financial Institutions and Consumer Credit
SPENCER BACHUS, Alabama, Chairman
STEVEN C. LaTOURETTE, Ohio, Vice BERNARD SANDERS, Vermont
Chairman CAROLYN B. MALONEY, New York
DOUG BEREUTER, Nebraska MELVIN L. WATT, North Carolina
RICHARD H. BAKER, Louisiana GARY L. ACKERMAN, New York
MICHAEL N. CASTLE, Delaware BRAD SHERMAN, California
EDWARD R. ROYCE, California GREGORY W. MEEKS, New York
FRANK D. LUCAS, Oklahoma LUIS V. GUTIERREZ, Illinois
SUE W. KELLY, New York DENNIS MOORE, Kansas
PAUL E. GILLMOR, Ohio PAUL E. KANJORSKI, Pennsylvania
JIM RYUN, Kansas MAXINE WATERS, California
WALTER B. JONES, Jr, North Carolina DARLENE HOOLEY, Oregon
JUDY BIGGERT, Illinois JULIA CARSON, Indiana
PATRICK J. TOOMEY, Pennsylvania HAROLD E. FORD, Jr., Tennessee
VITO FOSSELLA, New York RUBEN HINOJOSA, Texas
MELISSA A. HART, Pennsylvania KEN LUCAS, Kentucky
SHELLEY MOORE CAPITO, West Virginia JOSEPH CROWLEY, New York
PATRICK J. TIBERI, Ohio STEVE ISRAEL, New York
MARK R. KENNEDY, Minnesota MIKE ROSS, Arkansas
TOM FEENEY, Florida CAROLYN McCARTHY, New York
JEB HENSARLING, Texas ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey JOE BACA, California
TIM MURPHY, Pennsylvania CHRIS BELL, Texas
GINNY BROWN-WAITE, Florida
J. GRESHAM BARRETT, South Carolina
RICK RENZI, Arizona
C O N T E N T S
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Page
Hearing held on:
June 22, 2004................................................ 1
Appendix:
June 22, 2004................................................ 41
WITNESSES
Tuesday, June 22, 2004
Alix, Michael J., Senior Managing Director, Global Head of Credit
Risk Management, Bear Stearns, on behalf of the Securities
Industry Association........................................... 18
Dewhirst, Joseph, Treasurer, Bank of America Corporation......... 12
Elliot, Steven G., Senior Vice Chairman, Mellon Financial
Corporation.................................................... 9
Gilbert, Adam M., Managing Director, Global Credit Risk
Management, JPMorgan Chase & Co................................ 10
Jansky, Sandra W., Executive Vice President & Chief Credit
Officer, SunTrust Banks, Inc................................... 16
Marinangel, Kathleen, Chairman, President & CEO, McHenry Savings
Bank, on behalf of America's Community Bankers................. 14
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 42
Gillmor, Hon. Paul E......................................... 44
Alix, Michael J.............................................. 46
Dewhirst, Joseph............................................. 60
Elliot, Steven G............................................. 69
Gilbert, Adam M.............................................. 78
Jansky, Sandra W............................................. 81
Marinangel, Kathleen......................................... 90
THE NEW BASEL ACCORD:
PRIVATE SECTOR PERSPECTIVES
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Tuesday, June 22, 2004
U.S. House of Representatives,
Subcommittee on Financial Institutions
and Consumer Credit,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 10:10 a.m., in
Room 2128, Rayburn House Office Building, Hon. Spencer Bachus
[chairman of the subcommittee] presiding.
Present: Representatives Bachus, Gillmor, Biggert, Feeney,
Hensarling, Garrett, Murphy, Maloney, Moore, Lucas of Kentucy
and Frank (ex officio).
Chairman Bachus. [Presiding.] Good morning. Call to order
the Subcommittee on Financial Institutions.
At the end of this week, financial regulators from around
the world will release the newly negotiated Basel Capital
Accord, or Basel II. This accord has been heavily negotiated
over the past several years, and there has been significant
progress along the way. However, it is the view of this
committee there are still several critical changes that should
be made before U.S. financial regulators adopt Basel II.
Today, we will hold a hearing entitled, ``The Basel Accord,
Private Sector Perspectives.'' This is the third hearing that
the committee has held on the new accord. Prior hearings
highlighted disagreements among the Federal financial
regulators and led the subcommittee to the markup of H.R. 2043,
the United States Financial Policy Committee for Fair Capital
Standards Act, legislation which would mandate development of a
unified United States position prior to negotiating at the Bank
for International Settlements.
Following subcommittee approval of H.R. 2043 by a vote of
42 to zero, we have witnessed more cooperation among the
regulators and increased sensitivity to the opinions and
perspectives of all the stakeholders in the negotiations. I
hope this cooperation continues and that the Federal regulators
work together in the best interest of the United States banking
sector, financial industry and the U.S. economy as a whole.
There is broad agreement that the first Basel Accord needed
improvement. The global financial banking system has changed
significantly since Basel, and the old ways of measuring and
managing risk are simply inefficient. What has developed
through the Basel II process is state-of-the-art risk
assessment and management. However, there are significant
issues that still need to be addressed before the United States
endorses Basel II.
The leadership of the Financial Services Committee
submitted a comment letter to the financial regulators raising
several concerns with Basel II and the related ANRP. Concerns
related to operational risk, the risk weight for commercial
real estate loans and the impact this accord will have on
competition in consolidation within the financial sector were
all issues raised by this committee, and none have been
adequately addressed to date, in my opinion.
Under Basel II, banks will be required to take a new
mandatory capital charge for operational risk. The new charge
will require banks to hold capital against losses resulting
from inadequate or failed internal processes, people and
systems, or from external events. This definition includes
losses resulting from failure to comply with the laws as well
as prudent ethical standards and contractual obligations as
well as litigation risk.
I have heard from several financial institutions that there
is no widely accepted way to measure these losses and that
efforts to quantify operational risk losses are in the very
early stages. I would recommend that the Basel Committee
seriously consider not making operational risk charge a
mandatory one but rather one that is set on a case-by-case
basis by the regulator. Because operational risk is so
difficult to define, it makes sense for the regulator to know
it when they see it and then set a capital charge as opposed to
mandating the charge.
The Federal regulators often claim that the Basel II
proposal will continue to evolve and be flexible. If that is
true, the case should be an operational risk charge evolved
from Pillar 2 treatment to Pillar 1 treatment once it has
become easier to measure.
The U.S. commercial real estate market has proven to be
strong and is a key drive to our economy. Again, the committee
is concerned that, as drafted, Basel II will require a 25
percent risk weight increase for some acquisition development
and construction loans. This is highly problematic as it will
drive banks out of this type lending, stifling economic growth.
There have been tremendous advances in the assessment of
risk for this type of lending. Unfortunately, the Basel
Committee is not taking into consideration these important
advancements and is applying an unsophisticated standard for
the risk associated with this important lending sector.
I am concerned that the real goal here is to improve risk
management in Europe, Asia and other parts of the world.
However, U.S. lenders will be negatively impacted even though
they follow state-of-the-art management techniques in
acquisition, development and construction lending.
Competition in markets is key to ensuring that innovation
is encouraged, services are available and prices are kept low.
The Basel II Accord is going to apply only to the largest
financial institutions in the United States. However, there are
some institutions that will see compliance as a requirement to
remain competitive while others simply will not have the
resources or expertise to comply with Basel II.
My concern is that this two-tiered system will, through
regulation, force banks to merge, sell or change their business
models. This can mean a reduction in access to financial
products and to some increasing costs for consumers, all
because of a regulatory regime that was negotiated outside the
political process.
Basel II has the potential to radically change the way
banking is done in the United States. I understand that the
Federal Reserve has issued a white paper on this subject;
however, it is my understanding that that white paper looks
back at the effect of previous regulatory decisions on
industrial consolidation--or industry consolidation, not
forward. The fact is that none of the regulators actually knows
what effect Basel II will have on the U.S. industry.
I find it troubling that our regulators will be willing to
consent to such an agreement before the conduct a fourth impact
study, which is scheduled for this fall. Why not get the
results of this study before agreeing to Basel II? What is the
rush? If we are going to radically change the way banks assess
their capital, shouldn't we look at what the impact will be on
those institutions before signing on the dotted line?
I want to thank the witnesses for appearing today. We have
a diverse panel. I look forward to hearing your perspectives on
the Basel II Accord.
At this time, I will recognize Ms. Maloney for any opening
statement.
Mrs. Maloney. I want to thank the chairman, and I agree
that this is one of the most important issues before this
committee and that we should have the impact study before going
forward.
I, first, would like to defer to the chairman of the
committee, Mr. Frank.
Mr. Frank. Well, I wish that that is in fact what you were
doing, but you are----
Mrs. Maloney. Chairman for the Democrats.
Mr. Frank. Thank you. I think pretender to the chairmanship
is probably the actual title at this point.
Chairman Bachus. I didn't see you down there. I apologize.
I did recognize you now that I see you.
Mr. Frank. I thank you, Mr. Chairman. I am very proud of
the work this committee is doing on a bipartisan basis, and I
thank the chairman of the subcommittee, the chairman of the
full committee, the ranking member of the Subcommittee on
Domestic and International Monetary Policy which is really one
of the areas which this affects, although it is within the
jurisdiction of the Subcommittee on Financial Institutions.
When this whole process started, frankly, we were watching
the Federal Reserve simply go forward and do what it wanted to
do without a lot of input from anybody else, including the
other bank regulators. And this committee and members of this
committee were alerted to some problems by a wide range of
people in the banking community, let's be clear. We had some of
the large institutions that do custodial work who were worried
about the operational risk. We have the small bankers who
really now have reopened, fortunately, the whole Basel I
question and the impact competitively of differential capital
requirements.
And we have also, I think, uncovered a floor on America's
decision making, because these are very fundamental issues and
they were being done not only without any congressional input
but really without input from anybody outside the Fed, the way
it had been structured. We found that the Controller of the
Currency and the head of the FDIC and head of the OTS all felt
that they had been somewhat marginalized in the process, and we
now have a genuine process that is going forward, and I
appreciate that.
There is one flaw still there, or at least one problem,
that makes me less reassured than I am told I should be. People
have said, ``Well, don't worry because once Basel II is
affirmed internationally, it still has to be implemented by
each country's own laws.'' But with regard, certainly, to
operational risk, that means the Fed, I assume. I think the
entities that would be there would be the Federal reserves. So
we know that the Federal Reserve won't simply go forward with
it, and that is why it is important for us to focus on it.
I must say that I think we should, once this is put aside,
continue to look at the situation. We have a very
unsatisfactory situation from the standpoint of good governance
as to how America's position is formulated on these major
international issues, and I thank the chairman for having moved
that legislation, and I am certainly convinced that we should
continue our interest in this even after this is resolved one
way or the other specific of Basel II.
As to operational risk, I remain convinced that it is a
mistake to go forward with it. I think it is a case of doing
something that is easy and quantifiable because what really
ought to be done looks harder; that is, the management approach
is the one that ought to be taken, that this is almost a
disconnect in my mind between imposing a capital charge and the
risks we are dealing with here.
And I say that when we are talking about capital reserves
for loan losses, et cetera, we know what we are talking about.
We know a certain percentage of loans are going to go bad, you
can deal with that. Operational risk is of course a simple name
for a whole host of complex factors--of fraud, of physical
damage, et cetera--and it does not seem to me that the analogy
works, that the fact that you can put a capital charge for
economic losses which over time you can calculate predict, that
that translates into a whole bundle of unrelated kinds of
specific issues.
It is also the case that the experience, it does not seem
to me, that we have had argues for the need for this. We have
not had significant problems here which couldn't be handled
under the normal rules, and you clearly have the problem of
competitive disadvantage, particularly since we are talking
here, by definition, about international activities. It is
Basel II recognizing the international nature of this. So I
believe that the case fails, as I have seen it, for a capital
charge for operational risk, and I am concerned about the
negative implications--the negative effect that will have.
I also want to hear more about the argument that was raised
by various of the smaller banks and confirmed by the chairman
of the Federal Deposit Insurance Corporation, Mr. Powell, about
the competitive disadvantage. Now, maybe the view is that we
won't have to worry about that in 10 years because there won't
be any small banks. We read about Wachovia now, we have read
about B of A, we have read about Bank One and JPMorgan Chase. I
mean when I came here this used to be called the Committee on
Banking, Financial and Urban Affairs. We have now changed it to
Financial Services. If we were to take back the House, we might
go back to the old rule, because unlike our colleagues, we
don't think Urban Affairs is like a bad word, so we would put
it back in the title. But if we did go back, depending on when,
we might have to change it. Instead of it being the Committee
on Banking, Financial and Urban Affairs, in a few years it
might be the Committee on the Bank, Finance and Urban Affairs,
because I am not sure there will be more than a couple.
But for as long as we do have small banks, they ought not
to be at a competitive disadvantage. And, obviously, we believe
there should continue to be small banks. They play a very
important role. I will say I have had some good relations with
the larger banks that have merged in my area. It has also been
the case that when those merges have taken place, the small
borrowers, the local retailers, the local home builders have
said to me that they thought it was important that some local
banks also be around, because they have found that this is
their preference for dealing with them.
So preserving the ability of the community banks, the local
banks to perform their function is very important. It is not in
competition with the others; they have different niches, it
seems to me. But that issue also, I think, still is unresolved,
and I am grateful to those who have brought it to our
attention.
So with that, Mr. Chairman, I appreciate your convening
this hearing again, and I hope that we will get some
understanding on the part of the executive branch, particularly
people at the Federal Reserve, that it would be a mistake--let
me say, finally, it would be a mistake for them to go ahead
simply because they have the legal authority to do it in the
face of a significant lack of consensus. That is not a good way
to run regulatory affairs. You can't simply do that by fiat,
and I think it is clear from this ongoing process we are not
yet at the point of consensus that ought to precede a decision
of this magnitude.
Mrs. Maloney. Thank you very much. In the interest of time,
I would like to put my opening remarks in the record, but I
would just like to note my appreciation of the bipartisan
leadership on oversight on this important issue. And as we all
know, the discussions are now reaching a very critical stage
where key issues must be hammered out and not just at a
theoretical level but at a nuts and bolts level of detail that
will really determine how the new accord will affect the
financial services sector in the United States.
And because the new accord will affect financial
institutions differently, depending on their size and
portfolio, we have asked a large spectrum of banks and others
to attend and provide their view today. And our goal must be to
encourage a fair, competitive field for U.S. institutions in
the global market so that our institutions are not
disadvantaged in any way in requiring higher capital standards
or so forth. But we are also very concerned that banks within
the United States are not unfairly disadvantaged or that one
bank is not unfairly advantaged over another because of the
type or the size.
So we have asked each of you to address these points in
your testimony and of course to offer any other points that you
may have. As you may know, based on our concern on this
important issue, Chairman Bachus as well as Mr. Oxley and Mr.
Frank and myself, we have put forward and have introduced
legislation requiring U.S. legislators to develop uniform
positions in the negotiations and to report to Congress on any
proposed recommendations of the Basel Committee before agreeing
to it.
Regrettably, our legislation did not pass, but I believe
that our concern demonstrated--our legislation demonstrated our
serious concern and played an important part in advancing the
many hearings that we have had and the negotiations we have
seen today.
I join Ranking Member Frank and Chairman Bachus in really
urging that the report at least be completed and reviewed by
Congress before going forward and that no other consensus be
reached before making any international agreements that will be
binding on American institutions, on their safety and
soundness, their ability to compete here and the foreign
markets.
So I look forward to the contributions of the committee
today, of the witnesses today, and I thank them for being here.
Chairman Bachus. You are going to yield back the remainder
of your time? Okay.
At this time, I know that Ms. Biggert and Mr. Murphy are
going to introduce two of our witnesses, but, Mrs. Biggert, do
you have an opening statement?
Mrs. Biggert. I don't.
Chairman Bachus. Mr. Murphy, Mr. Hensarling, any opening
statements?
Mr. Moore, do you have an opening statement?
Mr. Moore. No, I don't.
Chairman Bachus. All right.
Mr. Lucas? Okay.
If there are no other opening statements, we will introduce
our first panel, in fact our only panel. So you all could be
our last panel too. Our first witness is Mr. Steven G. Elliott,
and I am going to recognize Mr. Murphy, the gentleman from
Pennsylvania, to introduce Mr. Elliott.
Mr. Murphy. Thank you, Mr. Chairman. Mr. Elliott is here by
popular demand in a return engagement. He is senior vice
chairman of Mellon Financial Corporation where he is
responsible for the corporation's Asset Servicing, Human
Resources and Investor Solutions. The corporation's Finance,
Treasury, Technology, Corporate Operations and Real Estate and
its Venture Capital Businesses also report to him.
His travels have taken him around the country with various
positions, everything from a degree from University of Houston
and business administration from Northwestern, he is also
worked with Crocker National Bank and Continental Illinois
National Bank and First Interstate Bank of California, so I
would say most of the States have probably seen his hand in his
abilities.
Mellon manages $3.6 trillion in assets under management,
administration or custody, and so his skills and knowledge of
these issues runs deep, and we are delighted to have him here.
Thank you, Mr. Chairman.
Chairman Bachus. Thank you, Mr. Murphy.
We welcome you, Mr. Elliott, to the committee.
Our next witness is Adam Gilbert. Mr. Gilbert is managing
director of JPMorgan Chase. He is currently the chief operation
officer for the Credit Portfolio Group, which is mandated to
actively manage the firm's retained risk resulting from failed
loan commitments and counterparty exposures.
In addition, Mr. Gilbert leads firm-wide efforts on various
public policy and industry issues, including revision of the
Basel Capital Accord and advises business and corporate
functions on supervisory and regulatory matters. He was a
member of the Corporate Treasury Group where he oversaw the
development of economic capital and transfer pricing policies
and supported the firm's Capital Committee.
He began his career in 1987 at the Federal Reserve Bank of
New York where for over 10 years he held positions in the Bank
Supervisory Group, Credit and Discount Department and Research
and Market Analysis Group. Interestingly enough, among other
things, he spent two and a half years in Basel, Switzerland as
a member of the secretariat of the Basel Committee on Banking
Supervision.
He graduated a Master's degree from Harvard University's
John F. Kennedy School of Government and Bachelor of Arts from
Tufts University where he graduated Summa Cum Laude and Phi
Beta Kappa. Is that a fraternity, Summa Cum Laude? No. All
right.
I hope you all know I am kidding.
[Laughter.]
When I campaign in some counties I say that is a
fraternity.
Our next witness--we welcome you, Mr. Gilbert. Our next
witness is Joseph Dewhirst--Dewhirst, I am sorry. And Mr.
Dewhirst is corporate treasurer at Bank of America. He is a
member of the Management Operation Committee and Assets
Liability Committee. He is responsible for managing corporate
and bank liquidity and capital positions. He is also
responsible for managing corporate insurance, economics and
certain aspects of the management of corporate pensions and
401(k) accounts.
He joined Bank of America as corporate treasurer just,
what, two months ago? Coming from Fleet Boston Financial where
he had been corporate treasurer. So you were merged into the
Bank of America.
Mr. Dewhirst. That is right.
Chairman Bachus. And he graduated also Harvard University--
I mean Harvard College, Harvard University in 1973 where he
majored in psychology and social relations, earned a doctorate
in social psychology from Harvard University in 1978. For the
past 16 years, Mr. Dewhirst has coached youth soccer in Sharon,
Massachusetts and served on the Board of the Sharon Soccer
Association. For two years, he served as president of the
association. I appreciate that.
Our next witness is Ms. Kathleen Marinangel, and I am going
to recognize Ms. Biggert from Illinois to introduce Ms.
Marinangel.
Mrs. Biggert. Thank you very much, Mr. Chairman. I am very
happy to welcome Kathleen Marinangel to the panel today. There
is an old adage that, ``Ask a busy person to do the job, and
they get the job done.'' I think this certainly applies to Ms.
Marinangel. She is not only the CEO and president of McHenry
Savings Bank but also the chairman of the board of directors,
and she serves on the board of the American Community Bankers,
which she is representing today and serves on the Basel II
Working Group Committee, along with many other committees.
She also is on the board of directors of the Illinois
League of Financial Institutions, Thrift Association's Advisory
Council, board of the directors of the Federal Home Loan Bank
of Chicago, Illinois Board of Savings Institutions where she
was appointed by the governor and serves to the president,
American Council of State Savings Supervisors, along with
another list.
She also has her pilot's license and community involvement
at Suntraga Board of Governors, City of McHenry Economic
Development Commission, McHenry Area Chamber of Commerce, along
with many others. I would like to welcome her here today.
Chairman Bachus. Thank you very much. Our next witness is--
and welcome you, Ms. Marinangel to the committee.
Our next witness is Ms. Sandra Jansky, SunTrust Banks. She
is executive vice president and chief credit officer. In this
role, she oversees the company's credit-related functions,
including credit policy, credit administration, credit and
capital market risk, special assets, credit review, credit risk
portfolio metrics and wholesale bank credit services. She has
extensive commercial banking experience, including corporate
and investment banking.
She began her career at First Union National Bank, served
there until 1981 when she joined SunTrust. She attended the
University of North Carolina, graduated from the Louisiana
State University Banking School of the South. She serves as
executive committee member of the International Board of Risk
Management Association and is immediate past chair. She is
former chairman and board member of the Foundation for the
Orange Public Schools in Orlando, Florida as well as various
other civic organizations. So we appreciate your service on
behalf of public schools there in Orlando, Florida and welcome
you to the committee.
Our final witness is Michael Alix. Mr. Alix is with Bear
Stearns. He currently chairs the Security Industry
Association's Risk Management Committee, and he will be
testifying on behalf of Security Industry Association. He is
senior manager and director and head of Bear Stearns Global
Credit Organization. As such, he is responsible for overseeing
independent counterparty credit risk management with focus on
the firm's global fixed income and equity businesses. He chairs
the firm's Credit Policy Committee and serves on its Risk,
Operations and Principal Activities Committees. He is also
active in the Bond Marketing Association.
Prior to joining Bear Stearns, he held a variety of credit
risk management positions at Merrill Lynch, including a Tokyo-
based head of Asia Credit. Holds a B.A. in economics from Duke
University and an MBA in Finance from the Wharton School of the
University of Pennsylvania. We welcome you, Mr. Alix, to the
committee.
With the introduction of all the first panel, we will
proceed to opening statements. We are going to start with Mr.
Elliott and proceed through to Mr. Alix.
So at this time, I will recognize you, Mr. Elliott, for an
opening statement.
STATEMENT OF STEVEN G. ELLIOTT, SENIOR VICE CHAIRMAN, MELLON
FINANCIAL CORPORATION
Mr. Elliott. Thank you, Mr. Chairman. My name is Steve
Elliott, and I am senior vice chairman of Mellon Financial
Corporation, a leading global provider of financial services
that has been serving its customers for more than 130 years.
Headquartered in Pittsburgh, we are a specialized financial
institution, providing institutional asset management, mutual
funds, private wealth management, asset servicing, human
resources and investor solutions and treasury payment services.
Mellon has approximately $3.6 trillion in assets in our
management, administration or custody, including more than $675
billion under management.
It is a pleasure to testify today before the subcommittee
on the potential impact of Basel II on Mellon Financial
Corporation and, more broadly, on the ability of U.S. banks to
serve their customers and investors. It was an honor also to
appear last June before this panel on this topic.
I am grateful for Congress' continued interest in the Basel
Accord. Your focus on this sometimes overwhelming technical
rule has ensured attention by regulators at home and abroad on
what the changes to the international risk-based capital rules
mean on the most important level: The ability of individual and
corporate customers to get what they need at a competitive
price from a vibrant U.S. financial services industry.
As a specialized financial institution serving pension
plans and the securities industry, Mellon has a special concern
with a particular aspect of the Basel II proposal: The new
regulatory capital charge for operational risk. We think much
in the proposed new international capital standards and low
regulations plan to implement them are quite good. Indeed, the
current risk-based capital standards need wholesale rewrite.
However, the overall need for new capital standards should not
distract from the critical importance of getting the details
right.
The operational risk charge could well have a dramatic and
adverse competitive impact on specialized banks. Trillion
dollar diversified banks can offer a broader range of services
to their customers; however, that is often done at a cost: The
inability to focus clearly on individual clients who want a
high degree of expertise and service in areas like asset
management and payment processing.
Mellon is grateful to you, Chairman Bachus, and the
leadership of this subcommittee, along with that of the
Financial Services Committee under Chairman Oxley and Ranking
Member Frank, for your continued attention to the many problems
with the operational risk charge, particularly its potential
adverse competitive impact.
You have rightly pressed the Federal Reserve to analyze the
Accord's competitive impact. We understand the board is
currently studying the operational risk-based capital charges
competitive impact. Mellon is of course happy to cooperate in
any way that would help in bringing about the right result.
The board has completed a study on the rule's impact on
mergers and acquisitions--a key question to ensure that the
Nation's banking system does not become too consolidated. I
would argue that there is a direct correlation between capital
and business activity, that if there wasn't, it would be hard
to understand why all of the U.S. and international banking
agencies have devoted so many years of hard work to the Basel
II rewrite. This is far from a technical exercise but rather
one of profound implications.
Today, I would like to emphasize the need for the Basel
rules and, especially the U.S. version, to rely upon effective
prudential regulation and enforcement to address operational
risk. An arbitrary regulatory capital charge for operational
risk, like the one now proposed, will have an adverse market
consequences that will ultimately undermine our customer
service.
The risk posed by the operational risk capital charge, even
in the advanced version proposed in the U.S. We continue to
believe that the ongoing improvements to operational risk
management will be undermined by the proposed capital charge,
creating perverse incentives for increased operational risk,
not the decrease that regulators desire and on which Congress
should insist.
And the importance of other changes to the U.S. version of
Basel II to ensure that our banks remain competitive and
focused on key market needs. This means a review of the complex
credit risk standards for specialized banks. A hard look at the
proposed retention of a leverage standard and the criteria for
determining who is a well-capitalized bank is also vital, since
these standards only govern U. S. banks and could have an
adverse competitive impact if retained.
Mellon respects the desire of the Federal regulatory
agencies in Basel and the U.S. to advance operational risk
management. That is why the Financial Guardian Group, to which
Mellon belongs, has answered the U.S. regulators' request for a
detailed and enforceable safety-and-soundness standard with a
comprehensive proposal. I have attached that proposal to this
statement for your consideration.
The U.S. regulators also have asked us for a safety-and-
soundness approach, called Pillar 2 in the Basel framework, to
be paired with an improved disclosure, Pillar 3, to back up
regulatory enforcement with market discipline. We took that
request very seriously and provided a detailed proposal which I
have also attached to my statement. The Federal Reserve Board
thanked us for our submission but does not appear to be
pursuing it as an option. However, we are still hopeful that a
compromise can be reached.
Thank you, and I will be pleased to answer any of your
questions.
[The prepared statement of Steven G. Elliott can be found
on page 69 in the appendix.]
Chairman Bachus. Thank you.
Mr. Gilbert?
STATEMENT OF ADAM GILBERT, MANAGING DIRECTOR, GLOBAL CREDIT
RISK MANAGEMENT, JPMORGAN CHASE & CO.
Mr. Gilbert. Good morning, Chairman Bachus, Congressman
Sanders and members of the subcommittee. My name is Adam
Gilbert, managing director in the Credit Portfolio Group at
JPMorgan Chase & Co. JPMorgan Chase is a U.S.-based
internationally active bank operating in more than 50
countries. We are currently in the process of merging with Bank
One, the Nation's sixth-largest bank holding company. Thank you
for inviting me here to discuss the proposed revisions to the
1988 Basel Capital Accord, more commonly referred to as Basel
II.
We commend the committee's continued interest in Basel,
which has been beneficial to the process and appreciate the
unique opportunity to have a constructive dialogue concerning
what we expect will be an improved framework for regulatory
capital requirements. We also commend the Basel Committee, the
US regulators and U.S. financial institutions for the openness
of the process and their role in developing the proposals.
Although there are a number of areas requiring further
consideration, the proposals to date do a far better job of
measuring risk than the rules they are intended to replace.
Please allow me to begin with a summary of our views and
conclude with areas we suggest warrant further review.
We strongly support the direction of Basel II. The three
pillars of minimum capital requirements, Pillar 1, supervisory
review of capital adequacy, Pillar 2, and market discipline,
Pillar 3, provide a solid framework in which to address safety
and soundness issues in an environment of continuous innovation
in the financial markets.
The committee's objectives with respect to Pillar 1 capital
requirements, that is improving the way regulatory capital
requirements reflect the underlying risks and incorporating
advances in credit and operational risk measurement techniques,
will address deficiencies related to the current regime and
have the potential to promote stronger practices at
internationally active banks. Today's capital rules treat all
borrowers the same regardless of credit quality and do not
address operational risk explicitly. Basel II will correct
this.
Ultimately, a bank's risk profile is best measured using
its full range of internal models. As an important step in that
direction, we welcome the advanced internal ratings approach,
which will permit banks to incorporate their own estimates of
default and loss recovery rates into a formula calibrated by
supervisors. We also welcome the advanced measurement approach
for operational risk which directly leverages banks' risk
measurement techniques.
There has been considerable debate about the
appropriateness of a Pillar 1 capital charge for operational
risk. We are highly supportive of a Pillar 1 approach rather
than a Pillar 2 approach, as some have suggested. A Pillar 2
approach would require banks to gather essentially the same
information as if they had a Pillar 1 charge, yet there likely
would be a loss of transparency and consistency in the
methodology applied across the global industry.
For about a year now, we have had an internal operational
risk capital charge in place which we believe is consistent
with the AMA standards. We have this charge because we are
fully cognizant that inadequate or failed systems, processes or
people can result in losses to our firm. The information and
control processes associated with our capital framework have
already provided significant value to our business and risk
managers.
The science around operational risk measurement will
continue to evolve, no doubt, but we believe that an explicit
Pillar 1 charge and associated standards will be beneficial in
this regard and will promote further discipline in banks'
operations.
In a few days, the Basel Committee will release a revised
version of its capital accord, reflecting comments from across
the financial services industry. The new version of Basel II
will incorporate positive changes related to the calibration of
the overall capital requirement, the measurement of credit risk
for wholesale and consumer businesses as well as guidance on
the practical application of the AMA.
We appreciate the fact that the Basel Committee has
committed to continue work on several important areas that we
believe necessitate further enhancements. These areas include
the treatment of counterparty credit risk, hedges of credit
risk and short-term exposures. There are several other issues
which merit clarification and modification, but these are
largely technical in nature. Additional information can be
found in our recent comment letters or I would be happy to
discuss these in greater detail during the Q&A.
To be sure, there is a lot for both banks and supervisors
to do to prepare for the implementation of Basel II. A primary
example is the qualifying process for the advanced approaches,
which will be very burdensome unless there is close cooperation
among supervisors. Home countries' supervisors must play the
lead role to ensure that the process for qualifying is
addressed at the consolidated level and that banks do not have
to go through separate approval processes in every country in
which they have a presence.
We understand that some local requirements might be
different for subsidiaries and possibly branches, but we expect
the home supervisor to help bridge the gaps when necessary. We
are confident the U.S. supervisors will do just that.
Chairman, I would like to thank you and the committee for
the opportunity to speak on these issues. This concludes my
remarks today, and I would be happy to answer any questions you
might have.
[The prepared statement of Adam M. Gilbert can be found on
page 78 in the appendix.]
Chairman Bachus. Thank you, Mr. Gilbert. And before I
recognize Mr. Dewhirst, I did want to say that, without
objection, your entire written statements will be made a part
of the record.
At this time, Mr. Dewhirst, you are recognized for an
opening statement.
STATEMENT OF JOSEPH DEWHIRST, TREASURER, BANK OF AMERICA
CORPORATION
Mr. Dewhirst. Chairman Bachus, members of the Subcommittee,
on behalf of Bank of America, I would like to thank you for
this opportunity to provide our comments regarding the Basel II
framework. I am Joseph Dewhirst, and I am the corporate
treasurer of Bank of America.
Let me begin by summarizing Bank of America's position on
Basel II. First, the overriding concern of bank regulators is
the safety and soundness of the banking industry, and, of
course, we share this concern. Capital is a buffer against
loss, and it seems sensible to us that bank management and bank
regulators assess the adequacy of bank capital by looking at
risk of loss.
Bank regulators worldwide used Basel I to formalize the
view that capital allocation should be risk-based. This capital
accord was, in our view, a major step forward in rationalizing
the assessment of the capital adequacy of banks. But Basel I
was, nevertheless, only an initial step.
As the industry has developed more sophisticated methods
for measuring risk, often dependent on computing power that has
become available only during the last decade, there has been a
growing need for more advanced regulatory capital requirements,
and Basel II is that more advanced approach. So we strongly
support the Basel initiative to better align regulatory capital
requirements with underlying economic risks.
Next, let me give a brief assessment of the progress made.
Our general view is very positive. Significant progress has
been made, and we commend the agency's leadership in this
process. While time-consuming and sometimes contentious, the
consultative dialogue maintained with the industry has improved
the transparency of the process and the quality of the results.
There are, nevertheless, several technical issues that
still cause us concern, and we summarized some of these issues
in a technical appendix; but we have every confidence that
these issues will be resolved before the final implementation
date.
Some have raised questions about operational risk. Bank of
America strongly supports the Pillar 1 capital requirements for
operational risk, because it aligns the regulatory capital
requirements with industry best practice. Recent history
provides ample evidence that operational risk can be
significant, and it deserves the same rigor of analysis that is
employed for credit and market risk.
Bank of America has already implemented explicit capital
charges for operational risk within its own internal systems.
We believe these models are almost fully compliant with the AMA
requirements, and it would be disingenuous for us to take any
position other than supporting the Pillar 1 approach.
Let me turn next to the competitive environment. We believe
that changes in capital requirements will not materially alter
the competitive landscape. In particular, well-managed banks
will not see significant change. To the extent that change does
occur, it will follow from more prudent management of risk and
more rational allocation of capital.
Bank of America believes that good risk management provides
a competitive advantage, irrespective of the regulatory capital
framework. Therefore, we have invested significant time and
resources to develop industry leading risk management processes
and economic capital models.
Correspondingly, Bank of America already manages its
business activities on the basis of risk-based capital. We
believe that these tools enable us to make better risk and
return decisions. Since we already manage based on methods
broadly consistent with Basel II, our behavior is not likely to
change in any material way.
Concerns have been raised regarding the prospects for
industry consolidation as a result of Basel II. Of course,
there are economies of scale in risk management. So at the
margin, by encouraging good risk management, Basel II may
encourage consolidation. But it will be insignificant compared
to other drivers of consolidation, such as the economies of
scale around product development, systems and staffing as well
as the benefits of diversification across business and
geography.
As indicated, we have a number of technical concerns. Under
Pillar I, work remains to be done on a calibration of capital
for mortgages and other retail assets. The current approach
assumes that there is inherently more risk in these assets than
seems justified. Under Pillar 2, we have concerns about
implementation of rules to create a level playing field
internationally. And under Pillar 3, we think that the
disclosure requirements of the standard are still excessive.
As I said, we provide details regarding these and other
concerns in the attached appendix, and I would be happy to
answer questions.
In closing, let me again assure you that we strongly
support the objectives of Basel II, and we have been pleased
both with the process and progress to date. While we
acknowledge and recognize outstanding issues, we believe these
issues can be resolved satisfactorily. Finally, we believe that
Basel II will encourage better management of risk and more
rational allocation of capital within the banking industry.
Thank you.
[The prepared statement of Joseph Dewhirst can be found on
page 60 in the appendix.]
Chairman Bachus. Thank you, Mr. Dewhirst.
Ms. Marinangel?
STATEMENT OF KATHLEEN MARINANGEL, CHAIRMAN, PRESIDENT & CEO,
MCHENRY SAVINGS BANK, ON BEHALF OF AMERICA'S COMMUNITY BANKERS
Ms. Marinangel. Mr. Chairman, Ranking Member Sanders, and
members of the subcommittee, my name is Kathy Marinangel. I am
chairman, president and chief executive officer of McHenry
Savings Bank, a $210 million institution in McHenry, Illinois.
I appear today on behalf of America's Community Bankers, where
I serve as a member of the board. Thank you for this
opportunity to testify on the impact that the Basel II Accord
will have on community banks.
I believe that the development and implementation of the
Basel II Accord will present one of the most significant
threats to community banks today, unless it is balanced by a
carefully revised Basel I Accord.
Since the adoption of the Basel I in 1988, the ability of
all financial institutions to measure risk more accurately has
improved exponentially. Community banks desire to adopt a more
risk-based sensitive model, such as Basel II. Unfortunately,
the complexity and cost of implementation of the Basel II
models will preclude most community banks from taking advantage
of the positive benefits.
I think the resultant disparity that will be created
between banks is totally wrong. Under the current proposal, my
institution would remain subject to Basel I. If it were
economically feasible, my bank would prefer to opt in to Basel
II. In fact ACB believes that any financial institution that
has the resources should be able to opt in to Basel II.
While there are a number or risks involved in determining
risk-based capital, an important one is interest rate risk,
which Basel I has generally failed to address for most
community banks. After barely surviving the high interest rate
cycle of the late 1970s and early 1980s, McHenry Savings Bank
adopted a strategic plan that included a goal to diversify
assets in such a way that the bank would never again rely on
one type of asset in its loan portfolio so that we could better
manage interest rate risk.
An important factor in this strategy was the ability to
reprice as many assets as often as possible. We believe that
flexibility and repricing is a key to survival in times of
fluctuating interest rates. For several years, McHenry Savings
Bank has repriced 80 percent of its assets annually.
Shortly after completing the restructuring of our
portfolio, in 1988, Basel I was implemented. Unfortunately, the
simplicity of the formula did not enable a determination of the
true risk of assets. Little or no consideration was given to
collateral value or loan to value of these assets. Thus, Basel
I has forced us to give up an asset mix that would reprice
frequently, something that we would want now in a rising rate
interest rate cycle. New options under Basel I are essential.
ACB supports the efforts of U.S. and global bank
supervisors to more closely link minimum capital requirements
with an institution's true risk profile. This approach could
improve the safety and soundness of the banking industry and
allow institutions to deploy capital more efficiently. However,
a bifurcated system will open the door to competitive
inequities.
Two banks, a larger Basel II bank and a small Basel I
community bank, like mine, could review the same mortgage loan
application that presents the same level of credit risk.
However, the larger bank would have to hold significantly less
capital than the small bank if it makes that loan, even though
the loan would be no more or no less risky than if a community
bank made that loan, assuming the large bank adopts Basel II.
Capital requirements should be a function of risks taken,
and if two banks make similar loans, they should have a very
similar required capital charge. ACB is concerned that unless
Basel I is revised, smaller institutions will become takeover
targets for institutions that can deploy capital more
efficiently under Basel II. As community banks disappear, the
customers will lose the kind of personalized service and local
decision making they want.
If Basel II is implemented for a portion of the banking
industry, changes must be made at the same time to Basel I to
maintain similar capital requirements for similar risk. For
example, I have developed a formula in appendix A that includes
more baskets and a breakdown of particular assets into multiple
baskets when taking into consideration collateral values, loan-
to-value ratios and other factors.
Whatever refinements are made, community banks must retain
the option to leverage their capital regardless of the
complexity of the calculations. Community banks must be given
the opportunity to compete against the international banking
giants who, by the way, have branches in my town and many other
towns across America.
We thank Chairman Bachus and the rest of the subcommittee
members for holding this hearing. As I mentioned at the outset,
there is no more important issue to community banks today than
the proper implementation of Basel II and the sensible revision
of Basel I. Thank you.
[The prepared statement of Kathleen Marinangel can be found
on page 90 in the appendix.]
Chairman Bachus. Thank you, Ms. Marinangel.
Ms. Jansky, I welcome your testimony.
STATEMENT OF SANDRA JANSKY, EXECUTIVE VICE PRESIDENT & CHIEF
CREDIT OFFICER, SUNTRUST BANKS, INC.
Ms. Jansky. Mr. Chairman and members of the committee, I am
very pleased to have the opportunity to discuss SunTrust's view
of the proposed capital accord. I am Sandra Jansky, executive
vice president and chief credit officer for the company.
SunTrust is the seventh largest domestic bank in the United
States. We have 1,201 offices located in 11 states, with 27,000
employees.
In my comments today, I will address our reasons for
choosing to become an opt-in bank, that is voluntary
compliance--I understand that has a different meaning in
Washington--but is a volunteer bank, and also discuss the
issues that we believe continue to be problematic.
Our financial institution believes that it is imperative
for us to comply with the provisions of Basel II. As a
conservative risk taker, we believe we have been required to
hold excessive regulatory capital without true consideration
for the composition of the risk in our institution. If there is
an opportunity to better align regulatory capital with economic
capital, we want to be able to qualify for such treatment.
We believe we have to move forward quickly to meet these
requirements under the accord due to our current size. By the
end of September 30 of this year, we will have approximately
$145 billion in assets. Due to the complexity and the vast
requirements recommended under the accord, it is impractical
for our institution to delay compliance with the proposal. We
believe delays would further add to the cost of implementation
and cost of compliance.
We also believe that we would be at a competitive
disadvantage compared to the core banks if they are able to
operate with lower capital levels than our institution. We have
considered voluntary compliance because it has made our effort
to try to work towards a better alignment more important to the
institution. As an opt-in bank, we have issues in meeting the
accord requirements, primarily because we are not at the table
with the core banks and the regulators when key issues are
explored and recommendations are made on a wide variety of
issues.
Core banks have the advantage of more focused regulatory
assistance as they pursue the advanced internal ratings-based
status. Volunteer banks need additional guidance and assistance
from the regulators that frankly is not currently available.
I have outlined in our testimony some of the benefits that
SunTrust has seen from beginning the implementation of the
Basel II Accord, primarily our risk rating system. As much as
we like certain aspects of the accord, we do believe the overly
prescriptive requirements as well as the level of complexity
will continue to challenge us as we move towards advanced
internal ratings-based status.
We continue to remain concerned about the special treatment
provisions required for certain specialized lending areas, such
as commercial real estate. While some change has been announced
to the original proposal, we believe that the higher capital
requirements for certain asset types without regard to the
specific risk management practices of a particular institution
or the performance of those assets over time is problematic.
We are also concerned about the correlation requirements
for residential real estate and home equity lines and loans
versus credit card products that we understand are in the
accord. The proposed treatment will impact the cost of credit
availability to certain product lines that have grown
tremendously over the last 10 years. The correlation
requirements proposed could result in higher capital to secured
equity products than unsecured credit card products. Our actual
experience in these products over a significant period of time
indicates the losses have been significantly below those
minimum requirements.
Of all the changes required for advanced status under Basel
II, the most significant for us is the quantification of
operational risk. The Federal Reserve has taken the position
that the advance measurement approach is the only acceptable
approach to calculating operational risk regulatory capital and
is therefore required if a bank wants to use the advanced
internal ratings-based approach to credit capital. We believe
this might place certain banks in the American banking industry
at a competitive disadvantage.
If SunTrust can satisfy the requirements for the advanced
internal ratings-based approach for credit risk and we fail to
meet some of the unspecified requirements for the advanced
measurement approach for operational risk, we will be forced to
continue with the current accord. A similar bank in another
country would have the ability to use the AIRB approach for
credit risk and the basic or standardized approach for
operational risk.
Finally, we have outlined some issues with the disclosure
requirements in my testimony. Primarily, we believe they will
add additional pages of information, highly technical, that
will be of little value to a vast majority of the readers.
SunTrust believes the new accord is a very positive step in
the right direction. We would like to see the regulators
establish a working group of the opt-in banks to further
enhance our ability to meet the requirements under the accord.
We also would request that the U.S. regulators consider
allowing banks to qualify for the advanced internal ratings-
based capital approach for credit risk, while considering the
standardized or basic approach for an interim period of time.
We also believe the asset correlations, as I mentioned earlier,
need to be addressed.
Thank you, Mr. Chairman.
[The prepared statement of Sandra W. Jansky can be found on
page 81 in the appendix.]
Chairman Bachus. Thank you, Ms. Jansky.
Mr. Alix?
STATEMENT OF MICHAEL ALIX, SENIOR MANAGING DIRECTOR, GLOBAL
HEAD OF CREDIT RISK MANAGEMENT, BEAR STEARNS, ON BEHALF OF THE
SECURITIES INDUSTRY ASSOCIATION
Mr. Alix. Thank you, Mr. Chairman and members of the
subcommittee. I am Michael Alix, senior managing director of
Bear Stearns and Company and global head of Credit Risk
Management. I am also chairman of the Securities Industry
Association's Risk Management Committee. I appreciate the
opportunity to testify on behalf of a group of those members of
SIA, including Bear Stearns, which are likely to be applicants
under the Security and Exchange Commission's new regulatory
regime for global consolidated supervision, otherwise known as
CSE.
My testimony today comes from the somewhat new perspective
of an investment bank viewing Basel II through the prism of the
CSE framework. I wish to make the following points. First, in
order for U.S. investment banks to compete on a level playing
field in Europe, we need to know now If the EU deems the SEC
program for consolidated supervision equivalent.
Second, regulators must coordinate and cooperate with
counterparts around the globe to ensure smooth implementation
of Basel II to avoid excessive costs and duplication of effort
that could impose undue burden on firms.
Finally, in order to ensure competitive equality, both
banking and securities regulators must address certain
remaining technical issues with the risk-based capital
calculations required under Basel II.
Let me say a few words about how we got to this point.
Major U.S. investment banks are likely to be subject to the
Basel Accord, including its risk-based capital standards under
the SEC's recently released consolidated supervision program.
One key driver of CSE is the requirement by the European Union
that firms operating in Europe are subject to comprehensive
consolidated supervision. That is why we care about Basel.
The day-to-day experience with Basel I and the leading role
of their banking regulators was a key reason why commercial
banks were involved closely in the development of Basel II. The
major investment banks and securities supervisors were, by
comparison, late to the table with respect to key policy
discussions with the framers of Basel II.
Initially, investment banks observed that the apparent
Basel II capital requirements for some of their key businesses
were out of line with perceived risk and actual loss
experience. I can report that firms have made significant
progress in the last year, clarifying how the calculations
should be made and conveying important technical flaws in the
accord through direct, constructive discussions with Basel
Committee members.
Detailed technical discussions with officials of the
Federal Reserve and the SEC enabled four large investment banks
to refine their calculations and complete a quantitative impact
study that informed our comments on the Federal Reserve Board's
advanced notice of proposed rulemaking.
The recent formation of a task force by the Basel Committee
and global securities regulators to follow up on many of our
concerns provides important evidence that the Basel Committee
takes seriously the unique perspective of the investment banks.
Now, for the remaining steps. First, and most importantly,
it is essential that we obtain an EU determination that the CSE
is equivalent. Originally, the guidance was to be announced by
the end of April this year with the first set of equivalence
judgments by June. These time tables have slipped, and we ask
that you and your colleagues on the full committee monitor this
situation carefully. It is our judgment that there should be no
doubt that CSE is equivalent.
Second, it is essential that all regulators coordinate and
cooperate with their counterparts around the globe on
implementing Basel II. Doing so will permit regulators to
leverage their resources, help ensure that no entity is subject
to duplicative or inconsistent requirements, and help ensure
that supervisory responsibility is lodged with the regulator
best situated to exercise such responsibility.
Flexibility in the application of the Basel standards under
CSE will be very important. U.S. securities firms have not been
subject to Basel standards on a firm-wide basis and thus have
not been obligated to build a global Basel I infrastructure.
Since banks will have until as late as 2008 to implement the
more advanced Basel II approaches, flexibility is necessary for
CSE applicants to avoid the undue expense and burden of
requiring implementation of a standard destined to be
superseded in the near future. In other words, if you decided
to build a new baseball stadium in the District in, say, two
years, you should not have to pay to renovate RFK right now.
The collaborative process must continue for international
capital standards to more fairly reflect the risks inherent in
the investment banking business, without imposing large and
unnecessary costs. Perhaps most significant among many still
open items is whether the SEC and other global regulators will
recognize the reality that much of our risk taking relates to
trading, rather than banking, activities that meet both the
spirit and the letter of the Basel Committee's definition of a
trading book.
Banks and securities firms operate and report under
substantially different accounting frameworks. Banks generally
carry risk assets at cost, accrue earnings, and establish
formula reserves. In contrast, securities firms mark to market
and treat virtually all business lines as part of a trading
book. If in the application of Basel II to investment banks
regulators require investment banks to compute capital
requirements for trading activities as though they are part of
a banking book, investment banks would be taking a double hit
in the computation of their requirements.
We very much appreciate the subcommittee's interest in the
adoption and implementation of Basel II. We look forward to
working with Congress, the administration and the regulators on
finalizing and implementing a new capital accord. Thank you
very much.
[The prepared statement of Michael J. Alix can be found on
page 46 in the appendix.]
Chairman Bachus. Thank you, Mr. Alix.
At this time, I recognize Mrs. Biggert for any questions
that you have for five minutes.
Mrs. Biggert. Thank you very much, Mr. Chairman. This is a
question I think that probably all of you could answer, because
there seems to be a difference of opinion in what type of bank
or institution you have. And that is what effect does the
regulatory capital have on your pricing and lending decisions?
And does the regulatory capital play a more important role in
the management of a community bank than it does for a large
financial institution?
I think I will start with Ms. Marinangel.
Ms. Marinangel. The second part of the question was does
the----
Mrs. Biggert. Does regulatory capital play a more important
role in the management of a community bank than it does for a
large financial institution?
Ms. Marinangel. I think the roles are similar. Currently,
we are all under the same regulations, and the mix of the
portfolio you have to live by the risk-based capital levels is
the same to maintain a well-capitalized bank.
Recently, for example, I have had to sell some very well-
collateralized commercial loans off to some of my competitors.
We have kind of coordinated in that. But to maintain the well-
capitalized level, my opinion is that maintaining mortgage
loans on your balance sheet, which are 50 percent weighted, now
will cause--even though it is a good credit risk, will cause
interest rate risk problems as interest rates rise. And,
therefore, I feel that the formula has caused problems for a
rising rates scenario, and I am sure it is similar for both
community banks and the larger banks.
Mrs. Biggert. Well, it is my understanding that at least in
the areas of small business and mortgage lending, that the
advanced approach of Basel II will likely result in significant
reductions in the required capital. And if this assumption is
correct, do you think that Basel II will make it more difficult
for small banks to compete?
Ms. Marinangel. Absolutely. I think that deploying capital
more efficiently and leveraging capital which will result from
the Basel II banks being able to opt in will cause community
banks to not be able to compete as effectively. The pricing of
the products, as you stated, when you utilize your capital more
efficiently, you can price some products at a lower price for
the consumer and make it up in other areas. And the larger
banks, some of them, offer credit cards and other products that
the community banks can't necessarily offer at an efficient
level. Therefore, it will make it extremely difficult for us to
compete if we are not able to opt in to Basel II or have a
revised I.
Mrs. Biggert. Okay. And I believe that the banking
regulators have recently announced they will consider revising
Basel I?
Ms. Marinangel. Yes. They have mentioned that they would
take it under consideration, and there would be two approaches.
Some community banks may not want to adopt the more advanced
Basel I, so they could be left as is or my example that was
attached shows more buckets are fairly easily administered, but
there could be also a more risk-sensitive approach that is not
as complex as the Basel II. And where additional risk for
complex and sophisticated products could be added in, could be
a Basel 1.5 and less complex.
Mrs. Biggert. I think you have the alternative proposal in
your testimony. Have you shared this with the banking
regulators?
Ms. Marinangel. Yes. I have sent thousands of letters over
the years, but most recently in November, when the comment
letter was due, I sent 1,000 letters out to those banks that
had less than 11 percent risk-based capital as well as all the
regulators. And I find that, for example, a mortgage loan, even
if it has a 20 percent or 90 percent loan-to-value ratio, is in
the same bucket, which makes no sense, and banks are not given
credit for the differences in loan to values, durations or
collateral. As another example, for the last 10 years in
McHenry Savings Bank, my commercial real estate loans have had
zero losses in 10 years. My overall loss has been less than
one-tenth of 1 percent on my whole portfolio because I am a
heavily collateralized lender, and I am not getting any credit
for my asset risk in that regard.
Mrs. Biggert. Thank you. I have just a short time left, so
if anyone else would like to comment on this? No statements?
Okay.
Yes, yes, Mr. Dewhirst?
Mr. Dewhirst. In general, I would say that regulatory
capital has no role or a de minimis role in pricing. The
principles that are the basis for regulatory capital, the risk-
based capital principles, do drive our pricing decisions, and
that has been true for a long time. But we don't focus on the
regulatory capital side of things in looking at those
decisions.
As Basel II is implemented, what will happen is the methods
of regulatory capital will become more in line with the pricing
disciplines that we are using already.
Now, to the general question of mortgages, I would tend to
agree with the comments that risk in mortgage assets is
overstated in Basel I. I would just make the observation that
Basel II is moving in the right direction in reducing those
risks, so to the extent that it is a more rational assessment
of the risk in those assets, that should help. The problems
that were mentioned about excessive risk weights for mortgages
are problems in Basel I that we would all hope to correct.
I don't really have a strong answer for whether regulatory
capital plays a more important role in the management of a
community bank. I know that we hold more capital at Bank of
America than is required by the regulators by a long shot. So
regulatory capital is not a constraining factor.
Mrs. Biggert. Thank you. Thank you very much. My time has
expired. Yield back.
Chairman Bachus. Thank you, Ms. Biggert.
Mr. Frank?
Mr. Frank. Thank you, Mr. Chairman. I haven't had a chance
to read the testimony, so I am upset at myself. I have a
fundamental question, maybe I am missing something. Sometimes I
find out when I ask fundamental questions I may not be the only
one who is missing something. And that is I am trying to
understand how it is that a capital charge is supposed to
alleviate, diminish, compensate for operational risk. I
understand a capital charge with regard to lending, and I know
you are not, on the whole, all advocates of it, but I want to
understand--I mean is it--there are a couple of possibilities.
One is that a capital charge somehow will give you an
incentive to avoid the dangers, I don't think anybody is really
arguing that. Is it that the amount of capital you have to put
aside, is that supposed to be able to take care of any losses
in operational risk so that we don't have to go to the fund?
What is the relationship? From their standpoint, as you
understand it, how will requiring you to put up this amount of
capital help us avoid the problems that would result from the
operational risks becoming real problems? Yes?
Mr. Gilbert. Thank you, Congressman. One can never say that
will help you avoid all problems. No capital charge could do
that at a reasonable cost. I think the best way to think about
an operational risk capital charge is in the context of an
entire risk management framework. It is not an end in and of
itself.
Mr. Frank. What contribution does it make to this? I mean I
can't look at the whole thing. I need to know what is better
because we have a capital charge for operational risk than if
we didn't?
Mr. Gilbert. Right. Because it makes the risk that we run
in our operations much more transparent, so the measurement
processes, the control processes that feed into the capital
make it much more transparent.
Mr. Frank. You don't have to have a capital charge to make
the risks transparent? Transparent to whom, I guess would be
the first question.
Mr. Gilbert. Well, it certainly makes it more transparent
to our internal businesses and risk managers. It provides them
incentives to control those risks----
Mr. Frank. How does it provide them an incentive to control
the risks that they don't otherwise have? I mean would a
capital charge go down if they----
Mr. Gilbert. Yes. In a risk-sensitive regime, if they have
stronger controlled mechanisms that are experienced----
Mr. Frank. And you mean the people running the operation
don't have an incentive to reduce those anyway? I am really
skeptical that a capital charge in terms of transparency
internally. I mean, first of all, doing a lot of capital
charges through management supervision would seem to do this,
but your argument is that the capital charge increases the
internal incentive to avoid the dangers and also makes people
more aware of what they are? It would seem to me there are
better ways to do that, and I would hope that they would be
doing that without this.
Mr. Gilbert. They largely do, but the capital charge
internally puts a highlight, a stamp on that, if you will, and
helps make transparent what it costs to the organization of
not----
Mr. Frank. Let me ask others what they think about either
that particular justification or some others?
Yes, sir?
Mr. Elliott. At Mellon, we take an entirely different
viewpoint here. Where we have tried to focus our resources----
Mr. Frank. No, no. I am asking you--Okay, well, go ahead
finish this if it is directly responsive.
Mr. Elliott. I think it will be, sir.
Mr. Frank. Okay.
Mr. Elliott. Where we have tried to focus our resources
around the operational risk side of things is not on a capital
charge, which really is in many ways a black box, especially to
people on the inside. But it is really to focus in terms of the
basic fundamentals of risk management, starting all the way at
our board of directors----
Mr. Frank. I understand, sir. Let me ask you this: Would a
capital charge give you any greater incentive, do you believe,
to deal with risk?
Mr. Elliott. Not in our view, no.
Mr. Frank. Yes. I mean I would think you would have--I mean
what are the operational risks? Are you talking about theft,
about fire, about----
Mr. Elliott. The more relevant ones, typically, on the part
of financial services that we deal with, which is more the
processing and asset management businesses, are errors in
pricing, there are errors like in not doing a corporate action,
recognizing a merger or an acquisition type of transaction, and
they are typically very modest in proportion if you----
Mr. Frank. Okay. But, again, I don't see--it does seem to
me you have every incentive to avoid those anyway, so I don't
see what a capital charge--what about transparency? Would a
capital charge increase transparency in your operation?
Mr. Elliott. No, sir, not the way we look at it. We would
see it in terms of basically having those strong internal risk
management systems is where your first line of defense----
Mr. Frank. Let me ask if any of the others have any--yes,
Mr. Dewhirst?
Mr. Dewhirst. You asked if there is an incentive created by
a capital charge. I think that the question or your skepticism
would apply equally if you asked the same question but changed
operating risk to credit risk or market risk. There are
incentives for good managers to manage credit risk. There are
incentives for good managers to manage market risk. The thing
is that people aren't perfect, markets aren't perfect, events
happen, things go bump in the night.
Mr. Frank. How does having a capital charge help then?
Mr. Dewhirst. Capital is there to protect the bank and the
bank shareholders and the----
Mr. Frank. Okay, but it is not an incentive. It is----
Mr. Dewhirst. The capital is there to protect against
economic loss.
Mr. Frank. Right.
Mr. Dewhirst. If the system is one that gives you a lower
capital charge to the extent that you are better able to
control your risk, whether it is credit or operating or
whatever, then you have an incentive to control that.
Mr. Frank. You think the analogy between credit risk and
operational risk follows very closely?
Mr. Dewhirst. Sure. In the examples mentioned earlier, many
of the operating risks mentioned were kind of minor and
routine, like fraud. And my opinion is they are not so much for
those routine losses as for the bigger ones.
Mr. Frank. Like what?
Mr. Dewhirst. Market timing, like late trading. If a
company doesn't have the right kind of controls in place over
its operations to make sure that people don't do those things,
they can lose a lot of money, and capital is there to make sure
that that----
Mr. Frank. Okay. Let me ask you this, though--and I would
appreciate a little extra time if I could--of course what you
are saying is if you have those controls in place, you will
then get a reduction in the capital charge?
Mr. Dewhirst. I would hope that eventually that is where
the system goes.
Mr. Frank. Oh, that is very attenuated. It is not
currently--you wouldn't get any today? Because it can't be an
incentive if you don't get it. Is that not built in today?
Mr. Dewhirst. Certainly, on the capital side, the direction
we would move----
Mr. Frank. No, I am not talking about on the operational
risk side. You are saying----
Mr. Dewhirst. There has been an evolution in the regulation
that starts with formulas like 20 percent risk weights for
securities and has evolved towards an actual assessment of
losses on credit risk. On the operating risk side, to the
extent that you have an advanced approach, what I would expect
to see happen is that your own data and models that project how
much you could lose would tend to support a particular capital
level, and as the regulators get more confidence in your loss
history and your projections of future losses, your own history
of good risk management ought to lead you to lower capital----
Chairman Bachus. Mr. Frank----
Mr. Frank. I have one last question, which is I thought we
were talking about unexpected losses, and how does that fit
into----
Chairman Bachus. Let me do this: Let me recognize Mr.
Murphy and then I will come back.
Mr. Frank. All right. I apologize.
Chairman Bachus. Mr. Murphy?
Mr. Murphy. Thank you, Mr. Chairman. I only have a time for
a quick question here, although there is nothing quick when we
are talking about the Basel Accord.
But a question for Mr. Elliott. I know the Fed has done a
preliminary study on the effect of Basel II on mergers and
acquisition activity within the whole banking industry. It
concluded that any potential drop in capital accompanying the
accord would have little impact on merger activity. However,
they did admit that because of relevant data, and I quote here,
``The results are statistically insignificant, and in cases
where results are statistically significant, quantitative
magnitudes are small.'' What is your opinion of the study and
statements like that?
Mr. Elliott. My perspective on that is that it is like any
study, it is a little bit backward looking, it is not forward
looking. And when you look in terms of the potential
consolidation of the financial services industry, obviously the
winners are going to be the ones that have the large capital
resources to basically provide acquisition opportunities. And
if you don't have strong capital, you are not going to
participate in the consolidation of the financial services
industry.
So my view would be it is an interesting study but more
backward looking, and any evaluation has to be more forward
looking in nature.
Mr. Murphy. Are there elements here in the accord which
would help or hinder--and I guess I will open this up to all
the panelists--help or hinder the flexibility of allowing
institutions to move forward in best ways with regard to
mergers and acquisitions. I mean the idea being that we don't
want it to just be a couple of big players end up acquiring
everything but allow the marketplace to work here. Are there
elements that you think help or hinder overall?
Mr. Elliott. Potentially it helps the larger financial
organizations to the extent they free up capital from some of
the other aspects of the Basel II Accord. You do have to take
into consideration, however, that basically the marketplace is
going to be the real determinant around the amount of capital
you need in a consolidating type environment. Others may have a
different view.
Mr. Murphy. Any other panelists have a comment on that?
Ms. Marinangel. I do. I think that when the larger banks
that would be able to adopt Basel II would be able to deploy
their capital, I believe that they would be able to buy a
competing smaller institution and then convert those assets
into a more efficient use by having less capital required. And
so I think that that will encourage mergers and acquisitions to
occur, because they will be able to deploy the capital of the
acquired bank.
Mr. Murphy. Is that a positive or negative?
Ms. Marinangel. Well, I think that perhaps for those
community banks that want to be sold, it is a positive. But I
think it is a negative long term because I believe that
community banks serve functions in the communities that the
large banks sometimes can't address. So I think it would be a
negative. There are a lot of de novos that are opening to
service the needs of communities as community banks.
Mr. Murphy. Thank you.
Mr. Gilbert, you had a comment?
Mr. Gilbert. Just to take a different view, I just believe
that regulatory capital will have no role in bank decisions
about whether to merge or acquire another bank. As Mr. Dewhirst
said, we make our decisions on all sorts of factors, largely
driven by our economic signals, economics of the marketplace.
Regulatory capital is not on the radar screen as a drive of
decision making in that regard.
Mr. Murphy. So we have some differences of opinion here?
Well, that helps clarify this point.
[Laughter.]
Mr. Murphy. Thank you, Mr. Chairman. I remain obfuscated by
the----
Mr. Dewhirst. I guess I would say or ask you in any article
you have ever read about a bank merger, did anybody ever talk
about regulatory capital as a driver? It is never on the table.
Ms. Marinangel. It could be, though, in the future because
of Basel II.
Mr. Murphy. Thank you, Mr. Chairman.
Chairman Bachus. Thank you, Mr. Murphy.
Ms. Maloney?
Mrs. Maloney. First of all, I would like to welcome one of
my constituents, Michael Alix, and thank you for your testimony
today.
I would like to ask you about your--you mentioned in your
testimony the trading book. Can you elaborate on this issue and
discuss how it may impact your firm and similar firms under
Basel II?
Mr. Alix. I would be delighted to, thank you. The trading
book is a concept in the Basel Accord which allows positions
and businesses to have their regulatory capital calculated
using a market risk model. And the idea behind the trading book
is that assets that are in the trading book are marked to
market, held for sale and actively managed as market risks.
That describes virtually all of the activities of the major
investment banks. There are some exceptions, but virtually all
of the inventory positions and activities in the investment
banks would be encompassed in a trading book.
However, it also includes activities which in commercial
banks are in a banking book, and a banking book is more of a
held-to-maturity traditional lending concept. And what we fear
from our discussions with regulators, both in the U.S. and
around the world, is that the activities that we have
effectively managed for years and years as market risks could
be recharacterized as banking risks.
That includes, for instance, mortgages purchased with the
intent to securitize, loans purchased with the intent to sell.
Those activities are recharacterized as banking book
activities. It has two harmful effects. Number one is it causes
us to have to build infrastructure to collect data and make
calculations on those activities that we wouldn't otherwise do
for our own purposes. We would not think it would be relevant
information.
And the other thing it does is to create a disparity in the
actual capital charge between the banking book and the trading
book such that investment banks, which have already recognized
the expected loss in the activity through the mark-to-market
process, would then be asked to take a capital charge on top of
that. The reserves, which banks would hold against those
activities, and which are, in some measure, expected losses,
would continue to be allowed as capital under the Basel Accord.
So that disparity would cause us a concern.
Mrs. Maloney. Thank you. Getting back to the point that Mr.
Frank was making, and I would like to ask all the panelists to
comment if they would, why would it not be more advantageous to
all United States financial sector institutions to move
operational risk to Pillar 2 and disclosure under Pillar 3? And
wouldn't that solve the competitive problems better and protect
better against risk, with the regulators and supervisors
looking at it. Would anybody like to comment on that?
Mr. Elliott. Well, that is precisely our proposal, and we
think one of the things that you have outlined is basically
getting to the heart of the matter. Each individual
organization is different here, and it is very difficult to
take something that is really unproven, basically mathematical
formulas, and try to level set it as it relates to a capital
charge. We think the aspect of regulators understanding an
organization and its activities well goes a long way to
answering the operational risk aspect. Disclosures, we think,
just continue to add to the transparency that has been
discussed. So we would be very much of a like mind with
yourself.
Mrs. Maloney. I would like all the panelists to answer if
they would. What would your position be on moving operational
risk to Pillar 2 and disclosure under Pillar 3?
Mr. Gilbert. Thank you. As I mentioned in my testimony, I
think if you had a Pillar 2 approach to operational risk, you
can imagine your supervisor coming to you and saying, ``Okay,
we are here to discuss how you handle operational risk and
whether you adequately address it in your risk measurement and
capital systems. So please now show us the data that you have
collected that helps us understand how you have adequately
addressed this particular issue.''
That is the same exercise, essentially, that you would go
through to have a Pillar 1 capital charge. In fact, if you did
that across the board, subject to standards that are broadly
agreed in the industry as part of Pillar 1, you would have a
much more consistent framework than a bilateral discussion that
would not only go on here but across the world for banks that
we actively compete with across a wide range of businesses. So
we just think it improves the transparency to make that a
Pillar 1 charge.
In terms of the point about unproven, I think we and other
banks have been doing operational risk internal capital for
some time. We think it is working quite effectively, and so we
would challenge the idea that it is unproven.
Mrs. Maloney. Sir?
Mr. Dewhirst. My comments are very similar. First, on the
consistency and transparency point, I think it is evident that
you would have more consistency and better transparency with
models that are publicly discussed and used----
Mrs. Maloney. But why would it be more transparency? Why
would it be more transparent?
Mr. Dewhirst. Imagine the situation, as Mr. Gilbert
suggested, where each regulator at each bank has a somewhat
idiosyncratic approach to assessing the risks at that bank. The
constituents who care about risk management at that bank,
shareholders for example, would not know exactly what
idiosyncratic standard those regulators were----
Mrs. Maloney. But if you had it under Pillar 2 and Pillar
3, which Pillar 3 is just disclosure, wouldn't it be totally
disclosed? If it is under Pillar 3, it would be totally
disclosed. Why wouldn't it be transparent if it is required to
be disclosed?
Mr. Dewhirst. Disclosure is an area where it is difficult
to achieve a standard which is high enough that everybody
learns what they--in other words, you have disclosures in a lot
of other areas that still create confusion, and I think that--
--
Mrs. Maloney. What if we had a standard for disclosure?
Mr. Dewhirst. If you have a standard for disclosure that
really explains how risk is being done in a consistent way
across the system, you would have to have a methodology that
was consistent as well.
Let me just add one other comment on the maturity of the
process. The comment that operating risk management is so new
that we can't do it I think is contradicted by the fact that
the insurance industry has been looking at these kinds of risks
and analyzing them in a very statistical way and projecting
losses for many, many decades. And what we are really talking
about is just an extension of many of those same techniques.
Mrs. Maloney. I would feel that it would be better to move
the operational risk to Pillar 2, the abstract nature of
operational risk. I believe a capital charge would not have any
significance towards operational risk, and I would not want to
see a capital charge for operational risk. I would rather have
it be disclosed or have regulators discuss it as they do
currently.
Ms. Jansky. I believe that we need to consider the fact
that it would take some time to develop for a lot of
institutions, perhaps not all of those that are at the table
today, but for a number of us to go back and develop all of the
information that is necessary and to develop that over long
periods of time to really build the models that support
operational risk at our institutional level. Our big concern is
it is going to take quite a bit of time, so we would support
moving to Pillar 2.
Mr. Alix. I think our firm and the firms I am speaking on
behalf of in theory agree with the idea of a Pillar 1
requirement and in theory agree that there ought to be capital
set aside for failures of people, processes and systems. Those
failures are inevitably going to happen, and there ought to be,
as we do a better job in the Basel II Accord, a much better
process of measuring and isolating the unique market and
credits risks, which for the most part create a reduction in
capital requirements. To have an isolation of capital for
operational risks would be, in theory, a good thing.
In practice, it is very difficult, and while some
institutions have made some significant progress, we, in
looking at some of the methodologies that are out there, are
somewhat skeptical of their applicability to our firms. And so
we would like to ensure that if we continue along the path of
having a Pillar 1 capital charge for operational risk, that it
be sensitive to the unique operational risks that our firms
wear and not try to apply a one-size-fits-all approach.
Mrs. Maloney. My time has expired--unless you had a point
to make.
Mr. Gilbert. I just wanted to make one additional comment
if I could. Basel II is a package that includes judgments to
credit and operational risk charge. If we were to remove the
operational risk component from Pillar 1 without knowing in
great detail, my sense is that the supervisors would feel
compelled to recalibrate the rest of the remaining Pillar 1 and
capital framework, and that is market risk and credit risk in
particular.
And I think that the law of unintended consequences would
take over, because you would force them to kind of recalibrate
in a way that would move the credit risk charge in particular
away from the underlying dimensions of risk, and that would be
unfortunate, because what we are trying to do in Basel II, in
the first instance, is link those risks more closely.
Mrs. Maloney. Could I do a brief follow-up question on this
just to try to clarify it from the statement and Mr. Gilbert
and Mr. Dewhirst? Basically, are you saying that because we
have several financial regulators, that we would not be able to
achieve consistency or transparency through supervision? Is
that your point? Could you clarify a little more?
Mr. Gilbert and Mr. Dewhirst, from your comments.
Mr. Gilbert. It is not just that we have several regulators
in the United States. We have regulators all across the world,
and so absent some very clear standards which are the core of
Pillar 1, because Pillar 1 isn't just a formula in which you
calculate a capital requirement but rather it comes with
operational standards that the supervisors expect the banks to
adhere to.
Without the consistency that is associated with those
standards as well as the calculation itself, what you end up
having through Pillar 2 is really a whole series of bilateral
discussions across--in our case, across 50 countries that
becomes unworkable and in inevitably will be inconsistent and
not transparent. And, therefore, we would be concerned about
something like that in the Pillar 2 framework, and the Pillar 1
framework makes that much more explicit.
Mrs. Maloney. Thank you.
Mr. Dewhirst. And I would just add that even if you imagine
a world where there were one regulator, you have different
examiners in charge of exams at various institutions, and there
is variability among the set of standards that they apply,
which is inevitable because they are people.
To the extent that you have a uniform approach that they
are attempting to adhere to, you minimize that, and
specifically you see a regulator issue a set of guidelines for
how they examine a particular risk. If you don't have
uniformity, then you risk a lack of consistency.
Mrs. Maloney. Thank you for that clarification, and thank
you for the time, Mr. Chairman.
Chairman Bachus. Thank you.
Ms. Jansky, in your testimony, you mentioned the arbitrary
minimum capital standards that have been set for commercial
real estate lending.
Ms. Jansky. Yes, sir.
Chairman Bachus. Why do you think that our U.S. regulators
agreed to these arbitrary capital lending minimums?
Ms. Jansky. I could only guess about that, sir, but I would
say that I think that a great deal of work apparently had been
done, and they were looking back in time and looking at asset
correlations and asset performance over the last two or three
cycles. My concern with that is there are a lot of other
factors that have to be taken into consideration. There were
lots of reasons for the different cycles that we went through.
There has been lots of change since those, particularly the
last commercial real estate cycle, as it relates to both the
introduction of FDICA but also it relates to the elimination of
the tax incentives that existed back in the 1988 era when we
had so much oversupply of product that was built, not because
of demand in the marketplace but frankly because of tax
incentives.
We have asked a lot of questions. We have asked for
empirical evidence, we have asked to see support, and we
frankly have just yet to see anything that we find that leads
us to that same conclusion.
Chairman Bachus. Do you think they could be more concerned
about maybe risk management in Europe as opposed to here?
Ms. Jansky. I can't answer that question, sir, I don't
know.
Chairman Bachus. Okay. But you have pretty clearly
testified that you believe it will have a negative effect on
commercial real estate lending in the United States?
Ms. Jansky. I believe it can have a negative impact in
certain products as we begin to rationalize and begin to work
towards an efficient utilization of capital, those products
that require higher capital, if you cannot get the right price
in the market or the price tends to be higher than perhaps non-
financial institutions providing that product, I do think we
will see it become an issue for certain markets. Yes, sir, I
do.
Chairman Bachus. And if the capital charges for certain
acquisitions and development and construction loans remain as
drafted, will SouthTrust--or SunTrust----
Ms. Jansky. I don't think SouthTrust is worried about it.
Chairman Bachus. New Wachovia, right?
[Laughter.]
Will SunTrust and other institutions, you think, be--I will
just say SunTrust--be forced to make fewer loans?
Ms. Jansky. I wouldn't say today, because I really think it
is too early to say that, that we would be forced to make fewer
loans, but I would say that that line of business, as all of
our lines of business, as we assess the capital required to run
our total operation as we get more efficient there, we will
look at the capital allocation for that line of business, and
it may force them to reconsider what their targets are in the
market.
Chairman Bachus. Okay. I will ask this question of all
witnesses. There have been significant innovations in
commercial real estate risk assessment that have been employed
in the last 10 years, and I think, Ms. Jansky, you mentioned
that. Do you believe that acquisition development and
construction lending has gotten more or less risky over the
past 10 years?
First of all, I will ask--just start with you, Mr. Elliott.
Do you think it is more risky or less risky?
Mr. Elliott. The perspective that we have is that we, in
essence, are not in that line of business, so mine would be a
little bit more as an outside observer. I think an outside
observer's perspective would be that I think people understand
the risks a lot more, they have monitored the risks a lot
better than what they would have historically, and people have
built their loan portfolios in a much more diverse manner so
that to the extent they do have any issues inside the
portfolio, they are able to handle them from a financial
perspective.
Chairman Bachus. Does Mellon do residential lending?
Mr. Elliott. Very selectively for high networth
individuals, yes.
Chairman Bachus. Okay. Do you think that that has become
less or more risky?
Mr. Elliott. I think it has become less risky because the
way that we do it. We have very low loan-to-value type ratios
associated with it, and we typically have other collateral
associated with those loans in addition to the property.
Chairman Bachus. But you all just aren't in that market
that much.
Mr. Elliott. We are not a significant player, no.
Chairman Bachus. How about, Mr. Gilbert, JPMorgan Chase and
I guess Bank One now?
Mr. Gilbert. Yes. Thank you. My new partners at Bank One I
think are more engaged in the real estate lending business than
we have been at JPMorgan Chase, but I think I would agree with
Mr. Elliott on the comments about the relative riskiness. But,
of course, the thing to keep in mind is that relative risk in
this type of activity is also a function of the State of the
economy, and we have generally had a benign economic
environment, certainly for in the nineties. We had some
problems early, of course, in this decade, but you can see that
it is a lot--that the economic environment on the whole is a
lot better than, say, the previous decade.
And I think if you take a long historical view, I think, as
the Fed has published in its study on real estate, you find
that this is not a riskless activity by any means, but you can
make relative risk statements about various points in time, but
I think what is most prudent to do is take the longest possible
historical view.
Chairman Bachus. Okay.
Mr. Dewhirst?
Mr. Dewhirst. My answer is colored mainly by my experience
in New England and history at Fleet there. New England went
through a very traumatic period in the real estate market in
the nineties. I think that taught people some lessons about
mismanagement and underwriting, and so I would say that market
has become much less risky over time. And I would also echo Mr.
Gilbert's comments that the business cycle seems to be becoming
less volatile, and that helps credit risk in general, including
both commercial and residential real estate.
Chairman Bachus. Ms. Marinangel?
Ms. Marinangel. I agree that the acquisition development
and construction lending have become less risky. Being in the
Midwest, that is generally a stronger economy, and because of
the interest rate cycles as well, I believe that it has become
less risky. Hopefully, it will stay that way, but when you have
good business environment, generally it is less risky.
Chairman Bachus. All right.
And Ms. Jansky, you have already testified that it has
become less risky, I believe, both residential and commercial,
in your opinion?
Ms. Jansky. Yes, sir. I would just comment that I believe
that we have had a lot that is happened over the last 10 years
and the advancement of risk management practices in our
industry. I also believe there is a great deal more
transparency in the commercial real estate market. I also
believe that real estate developers have had a much more
consistent approach to market and have been somewhat more
conservative than I observed over the last 25 years in the
business.
Having said that, I am not sitting here today and saying
that there won't ever be additional real estate problems
because there will, but I believe that the industry has done a
very, very good job, and I believe a lot of regulation in
certain areas, but at the time we would have been careful but
now it looks to me like we are very prudent and it has helped
us to make sure that we are managing that risk. And I think the
industry as a whole is managing it much better.
We also have to remember that we have had some very high
vacancy factors across the country in different markets. We
have had lots and lots of new starts that have been pulled from
the market, but we have been in an incredibly low interest rate
environment. So you have to balance all of that as you look at
the relative risk. But we feel very comfortable with it, and we
just want to see a lot more documentation and more of a forward
thinking about the risks associated with commercial real
estate.
Chairman Bachus. Mr. Alix, Bear Stearns is not really in
that market.
Mr. Alix. I would suggest that we are but in a very
different way than the other panelists. One of the things that
hasn't been mentioned I think as a positive in commercial real
estate lending has been the enormous development of a robust
capital market for securitized commercial real estate loans.
And our firm, as well as others in the industry, have a
very active business in originating and purchasing loans from
other originators, packaging those loans in large and diverse
packages--diverse by geography, diverse by property type, et
cetera--and selling pieces of those securitizations to
institutional investors.
That has diversified the ultimate holders of the risk and
has ensured that if there were a problem, another problem in
commercial real estate lending, the pain would be distributed a
little bit differently than it was the last time around. So I
think that is a very positive development.
I also believe that this is an area where our argument for
trading book treatment is crucial, because these are loans that
if we applied banking book, which the other witnesses argue is
extremely conservative, if we apply banking book capital
charges to our commercial real estate loans held for
securitization, it would have a very detrimental effect on the
regulatory capital charge.
Chairman Bachus. All right. Thank you. You know, I will say
we are going to hold a hearing tomorrow on non-prime lending,
and I am sure we will touch on securitization in that lending
is somewhat threatened by some liability questions, as you
know.
I will say this--I am going to yield to Mr. Frank for as
much time as he may consume. Before I do that, I do want to
say--I want to offer one cautionary note that I have as far as
the residential real estate lending market, and that is we have
been in a historic period, I would say, for the past several
years of low interest rates where people that weren't able to
afford mortgages before because of low interest rates were--
many of those residential mortgages are adjustable rate
mortgages.
And I am not sure that if we have rising interest rates out
of a very low interest rate, residential mortgages and
adjustable rate mortgages as opposed to fixed rate mortgages, I
am not sure what kind of stress that will put on the market. I
am not sure that we--I am sure you all factored some of that
in. Anybody want to comment on that? Is that a concern?
Mr. Alix. I would suggest, as a firm that has a significant
mortgage capital markets business, that prudent risk management
would compel us to do sensitivity analysis and stress analysis
for the sort of scenario that you are describing. And one
observation would be that the market seems to have absorbed the
increase in volatility and interest rates in the mortgage
markets quite well, but time will tell as to whether the
ultimate home value and delinquency rates are affected by a
materially higher interest rate environment.
Chairman Bachus. All right.
Mr. Dewhirst?
Mr. Dewhirst. Well, certainly, it is a concern, and it is
one that we have looked at for many years. When you get burned
once in a particular area, you tend to focus on that for the
rest of your life. The one caveat I would put around the growth
in the ARMs market is that many of the most popular ARM loans
have a fixed period that is quite long in the front. So I just
bought a house myself in Charlotte, preparing to move down
there, and it is not only an ARM but there is 10 years of fixed
rate in front of it.
So I think there is a possibility that in just looking at
aggregate ARM numbers, we can exaggerate the exposure. Many of
the people that have 5-, 7-, 10-year ARMs will have moved or
refinanced by the time that those fixed rate periods end.
Chairman Bachus. That is a good point. I am not sure I was
considering that.
Mr. Frank?
Mr. Frank. I want to return to the question of incentive,
et cetera, and I would say I agree with Mr. Dewhirst. I have
advanced the argument that you can't do the operational risk
capital charge because we don't know how to measure it, but it
does seem to me that acknowledging that they have made
significant progress in measuring it cuts the other way as
well. That is, I understand the importance of some uniformity
and standards and the problems of inconsistent application.
I don't understand what a capital charge adds to that. That
is, why can't you do all those things you were talking about,
promulgating uniform standards, et cetera, under a management
approach? What does promulgating a number, a capital charge,
add to that administrative procedure, because I agree with
everything else you have talked about.
The second point I would have is this: You said that the
incentive works this way, which is logically straightforward as
you say it. Once there is a capital charge, you would get an
incentive to improve your procedures because that way your
capital charge could be lowered. But the people who would
decide to lower the capital charge are the people who are
checking. I don't understand why you would still have the same
group of people monitoring your procedures.
Now, without a capital charge, they are monitoring your
procedures and passing on their adequacy. With a capital
charge, they are monitoring your procedures and passing on
their adequacy so they can reduce the capital charge. I
literally don't understand how a capital charge adds to the
transparency, the rationality. All those things could be done,
it seems to me, by administrative regulation and requirement
without a capital charge.
So, particularly, for Mr. Gilbert, I guess, and Mr.
Dewhirst. I would be interested in your responses.
Mr. Dewhirst. Let me make two--well, a comment and ask a
question, sort of turn it around and maybe I can get clarity on
what your concerns are.
Banks already hold capital. There is implicitly a capital
charge for operating risk. If large losses occur because of
operating risk losses, the shareholder pays.
Mr. Frank. Mr. Dewhirst, I understand that, but that is not
answering my question.
Mr. Dewhirst. Well, then let me try to understand it by
asking this.
Mr. Frank. Go ahead.
Mr. Dewhirst. We insist on a certain approach to credit
risk. We say there ought to be a methodology for deciding how
much risk there is in the assets we have, what the possibility
is of unexpected losses occurring in those assets, and we ought
to have capital that is scaled to that. What is different about
operating risk?
Mr. Frank. Well, I think there are some differences in
terms of what you are dealing with. Loan losses are expected,
but I do want to go back to your question. I have to say this:
When you don't want to answer my question but want to ask me
one in return, it suggests to me you haven't thought of the
answer yet. I will take it in writing later.
But you were saying that a capital charge deals with the
following problems. First of all, it deals with the problem of
inconsistent regulators. Was I correct in hearing you that way,
that you said that one of the problems that leads you to be for
capital charge is the difference and inconsistency among
regulators; is that correct?
Mr. Dewhirst. A capital charge under the advanced approach.
We could do that.
Mr. Frank. Yes. Right. And that is a way to get around--to
diminish the problem of inconsistent regulators. It would
increase transparency. You would have one set of standards. My
question to you is why can't you accomplish all of that by
regulation and by promulgations without a capital charge and
don't in fact even if you have a capital charge, you still need
to get them together and do that.
I think that what you are saying is, well, only if there is
a capital charge--the capital charge in and of itself doesn't
do any of that. The capital charge does not homogenize or
regularize or get uniform. You still have the individual basis.
Why is the capital charge necessary to achieve all those other
things which I think we ought to achieve?
Mr. Dewhirst. You may be able to achieve consistency and
transparency without the capital charge.
Mr. Frank. No, that is not my question. My question is what
does the capital charge add to it?
Mr. Dewhirst. I understand. What it adds is what capital
adds for every other risk, which is a cushion against loss.
Mr. Frank. Okay. Then that is a different question, I
understand that. And that is what I was asking my question, but
that is a different justification than the one you gave. That
is fine.
Mr. Dewhirst. It was----
Mr. Frank. Excuse me, I am going to finish. I have to be
honest with you, even if you weren't moving out of my district,
I would still interrupt you. You are moving to Charlotte, so I
don't mean to--I do that with people.
Mr. Dewhirst. Not before the next election.
Mr. Frank. Weak opposition this time. It is not a problem.
[Laughter.]
But here is the point. Here is the point: If you had said
that originally, we wouldn't be having this discussion. I
understand that argument that a capital charge is there to
provide money to make up for the risk, but in addition to that,
and I really think you have to deconstruct all these arguments,
there is an argument that a capital charge incentivizes you, et
cetera.
In other words, one argument for capital charge is that it
diminishes the likelihood that there will be risk which the
capital will be used to fill up, and the argument that you need
a capital charge to deal with losses, I understand. I would
have dealt with that earlier if we had gotten to it earlier.
The argument that a capital charge improves the quality of
regulations somehow increases transparency and deals with the
problem of inconsistent regulation, I am unpersuaded.
Mr. Dewhirst. Let me make a distinction. Again, it is based
on my analogy to the credit risk capital framework. Under Basel
I, all commercial loans were 100 percent risk weight. Not all
commercial loans have the same amount of risk. The capital
charge did not do anything for transparency or did not do much
for transparency. It did a lot for consistency but not a lot
for transparency. It certainly didn't tell the shareholder or
the debt holder in a particular bank whether the loans were
extremely risky or not.
The advanced approach goes to a very different standard
where the capital assigned is going to be proportional to the
risk assessed, based on estimates of probability of default,
loss if default occurs, exposure and so on. Under that system,
there would be an incentive--the capital charge would create an
incentive for better risk management, because to the extent
that you could reduce probability of default or loss given
defaults, you would have a lower capital charge. Now, if we
can----
Mr. Frank. But you have a lower capital charge only if the
regulator examined your procedures and felt that you had
achieved increased efficiency and therefore you were entitled
to a lower capital charge.
Mr. Dewhirst. Yes.
Mr. Frank. And my question to you is why can't we have the
regulator do that without the capital charge? In other words,
in each case--excuse me, I want to finish this--in each case,
we are relying on the regulator's analysis of what you have
done and the regulator having analyzed what you have done says,
``Oh, you did a pretty good job.'' Well, why can't we give the
regulator the power to enforce that? Why does he need the
ability to reduce the capital charge to have the ability to do
that?
Mr. Dewhirst. If you again go to the credit example, with
100 percent risk weights for all commercial loans, the
regulator comes in----
Mr. Frank. Well, you are going back and forth with the
credit example. The credit example is sometimes relevant and
sometimes isn't. If you can't answer it in terms of the
operational risk, then I am skeptical.
Mr. Dewhirst. The analogy to operating risk would be
exactly----
Mr. Frank. Well, explain to me then why does the regulator
need a capital charge to be able to look at those procedures,
evaluate them and pass judgment on them?
Mr. Dewhirst. They don't, but then what happens?
Mr. Frank. Okay.
Mr. Dewhirst. In order for there to be an incentive--I mean
there could be banks that are extremely well capitalized, very
well capitalized, marginally well capitalized that a regulator
would come in and--I mean a regulator just wants to have a
certain level of capital so they can ensure the safety and
soundness.
Mr. Frank. I didn't say that. That is the loss to me. That
is a separate argument, and I would like to return to the one
we are talking about. It is very important to sort them out.
Mr. Dewhirst. I am sorry, say that again.
Mr. Frank. That is the loss provision, to make up for
losses, but that is a separate one from the--I mean I did
notice you said it didn't add to transparency. I mean I am
trying to understand what it is over and above capital to make
up for losses that makes it important to have a capital charge.
I don't understand how it adds to transparency, how it adds to
the incentive, how it--I mean you still haven't gotten to me on
that.
Mr. Dewhirst. Under the current system, I would say
transparency is minimal because--and I am going to the lending
approach because what is happening now is the regulators are
trying to make the operating risk approach more like the
lending approach. But under the current lending approach, 100
percent risk weight for all commercial loans, it is very hard
for anybody to know what is going on, because it is 100 percent
for every kind of loan. You don't get detail.
If the system went to the advanced approach and capital
were allocated by risk, then you would know both from the
process and probably from the disclosures that banks that had
more capital for credit risk had more risk.
Now, if you did the same thing under the operating risk
framework, you could have two different approaches. One
approach would just be all banks or all financial institutions
have a certain level of risk. One of the early Pillar 2
approaches said operating risks in proportion to revenue.
Mr. Frank. That is a strawman, nobody said that. But it is
a strawman, it doesn't help us to throw it in here.
Mr. Dewhirst. But it is very similar to----
Mr. Frank. No, it isn't. What we are talking about is--we
have agreed that there needs to be--and I am going to end this
now because we are not getting anywhere--we need--yes, we want
to have a system whereby the regulators look at things
individually and at the same time you want both individuality
and uniformity. You want regulators looking institution by
institution, but you want regulators with each institution to
have a somewhat similar approach. I agree with that. I just
don't understand how at the end--beginning or ending with a
capital charge in any way makes that likelier or easier to
accomplish.
That is all, Mr. Chairman. We are going to end where we
began.
Chairman Bachus. Thank you. I am going to go ahead now and
ask a question, and then Ms. Maloney will wrap up, but at least
you have some----
Mr. Frank. I am going to lunch, Mr. Chairman. I am going to
go have lunch.
Chairman Bachus. We are all going to lunch pretty quick
here, including some students over here.
I have one question. It is actually for Mr. Alix, it is
something you raised in your testimony. This spring we heard
testimony from the U.S. and European government officials
regarding the consolidated supervision issue. You talked about
your concerns there. Last week, the International Subcommittee
heard testimony from the U.S. financial sector regarding this
issue as well. The securities industry in particular has now
asked the committee I think for two weeks in a row to keep a
close eye on the implementation of the commission's
consolidated supervision directive.
So my question is this: What should members of this
committee do in monitoring this situation?
Mr. Alix. Well, first, I would say, as I said in the
testimony, that we believe it should be unambiguous. There is
no doubt that the SEC's form of supervision, which is embodied
in the consolidated supervised entities rule, is first rate,
world class, equivalent to the best supervisory programs around
the world for financial institutions. And I think that the best
thing that the people in this room and elsewhere in this city
can do is to push the European representatives to abide by
their deadlines in making that determination.
And if that determination is made, for instance, in the
next few weeks, I think that will enable U.S. investment banks
to get on with the business of making their applications and
getting the exams done and putting themselves in a position
without undue cost or burden to meet the requirements that the
SEC has put forward. If there is a delay, that could be very
damaging, both from the perspective of having to do more in
less time as well as from the perspective of having the
commission distracted by that particular issue still being
open.
So we want it to be unequivocal, clear and final as soon as
possible, and anything you can do to make that concern known to
the appropriate people would be appreciated.
Chairman Bachus. What if the European Commission and I
guess the parliament can't conclude or finalize their work and
make the necessary determinations in a timely manner? What
could the Financial Services Committee do about this
internally?
Mr. Alix. Well, first of all, I don't think the equivalence
judgment is a matter for the European parliament. I think that
has been delegated to each firm's respective regulator of their
principal activities in Europe. And so that is a matter for the
regulatory agencies in Europe. To be honest, I think it is not
something that we contemplate.
As I said, it is so obvious to us that it is something that
we believe ought to be done right away. Were that not to
happen, I think that would be sufficiently serious that it
would inspire very high level across-Atlantic conversations
about the implications, and I think that for our firms the
prospect of having our operations ring fenced in Europe and not
being able to enjoy the benefit of global franchises would make
it very difficult to compete in some of our core businesses in
Europe. And I think that would be very detrimental.
So, as I said, I would like not to contemplate a
significantly longer delay or a decline of equivalence status,
but if that were to happen, we would be very, very concerned.
Chairman Bachus. I would ask all of you if your firms or
your corporations have researched whether the regulators in the
various countries have the legal authority to share supervisory
information or oversight responsibilities, possibly join
together in enforcement actions across borders?
Mr. Gilbert. I am not sure we have researched it as such. I
think in those matters we tend to rely on the supervisors to
discuss among themselves their ability to share information and
pursue actions. We, of course, need to abide by the local rules
that apply to the sharing of information, even within our own
firm, so there are a lot of rules and requirements out there
that can vary from country to country. But in terms of the
ability of the supervisor to share information----
Chairman Bachus. And really legal authority.
Mr. Gilbert. Right. We tend to have not looked per se at
that issue but, again, rely on the bank supervisors themselves
to determine that.
Mr. Alix. If I might add, I would agree that it is a
question better placed with the regulatory authorities here who
have done the legal research, but it is my understanding that
the SEC in the case of the investment banks has negotiated
agreements with the relevant regulatory authorities about the
protection of private information that they exchange in the
course of their supervisory activities.
I think it is kind of interesting because we actually
support cooperation among regulators to avoid, for instance,
being asked the same question or being asked for the same
information by 10 different regulators around the world. We
would encourage them, where appropriate, to consult with each
other and share information where it is directly relevant to
carrying out their activities.
Chairman Bachus. All right. This concludes our hearing, and
members will have five legislative days to submit opening
statements. And the chair notes that some members may have
additional questions for the panel, which they may wish to
submit in writing. Without objection, the hearing record will
be held open for 30 days for members to submit written
questions of those witnesses and to place their responses in
the record.
With that, this hearing is adjourned.
[Whereupon, at 12:15 p.m., the subcommittee was adjourned.]
A P P E N D I X
June 22, 2004
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