Each depositor insured to at least $250,000 per insured bank

Chairman Shelby, Senator Sarbanes and members of the Committee, it is a pleasure to appear before you today on behalf of the Federal Deposit Insurance Corporation to discuss current developments regarding Basel II.

As you know, Basel II is an international effort to create standards for capital requirements that would allow banking institutions to use internal estimates of credit and operational risk to determine their minimum risk-based regulatory capital requirement. Basel II is intended to be a framework that is more risk-sensitive and one that promotes a more disciplined approach to risk management at our largest banks. Basel II has been developed to respond to concerns that the regulatory arbitrage opportunities available under Basel I threaten the adequacy of the regulatory capital buffer needed to ensure financial system stability. It is important to remember that an overarching objective of Basel II is to reinforce capital adequacy standards by better aligning minimum capital requirements with risk and thereby prevent an erosion of the aggregate level of capital in individual banks and the banking system.

The FDIC supports these broad goals and is actively engaged in the regulatory process to develop a new capital framework for the United States. As the U.S. banking and thrift agencies move forward to implement Basel II, we must ensure that the new capital framework does not produce unintended consequences, such as significant reductions in overall capital levels, the creation of substantial new competitive inequities between certain categories of insured depository institutions, or an expansion of the federal banking safety net by blurring the regulatory lines between banks and holding companies.

About six weeks ago, the U.S. agencies announced a plan for moving forward with the implementation of Basel II in the U.S. I participated in and support that plan because Basel II has the potential to represent positive change in capital regulation for our largest banks. Basel II clearly requires a more sophisticated approach to risk measurement by the adopting banks. At the same time, however, the most recent quantitative impact study, QIS-4, showed both a very large reduction in capital requirements for many banks, and large differences in capital requirements for what appeared to be identical risks. All the agencies agreed that the results of the impact study were unacceptable and that more work remains to be done to address these concerns.

QIS-4 was a comprehensive effort drawing upon data submitted by 26 of the largest U.S. banking organizations designed to provide the agencies with an improved understanding of how Basel II affects minimum required capital at the industry, institution and portfolio level. A comprehensive review of the QIS-4 results, conducted over the spring and summer of this year, raised many questions and concerns. The agencies' preliminary review of QIS-4 data indicates that, relative to Basel I, minimum risk-based capital requirements under Basel II will be reduced for most of the banking organizations in the study—substantially in many cases—to levels that the FDIC does not consider commensurate with the risks to which these institutions are exposed. Further, the results indicate a wide dispersion of results at both the banking organization and portfolio or business line level, including material differences in capital requirements for identical, or virtually identical, credit exposures.

These QIS-4 results pose a dilemma for the agencies. QIS-4 suggests that the present framework will produce unacceptable capitalization outcomes. Yet, committing to specific changes to the framework at this time, without the benefit of further experience and industry systems development, would be premature. That is why, on September 30, 2005, the agencies announced that we will move forward with a Basel II Notice of Proposed Rulemaking (Basel II NPR) that includes additional time for bank systems development with added prudential safeguards. Those safeguards include more conservative risk-based capital floors, and a clear signal that changes to the framework will be made based on further experience. Ultimately, changes to the Basel II framework are likely to be required to avoid unjustified and imprudent reductions in overall capital levels and to reduce the potential for wide variations in capital requirements for similar types of exposures. While improvements in risk management practices and risk profiles may justify lower capital under Basel II, the FDIC believes that a correctly calibrated Basel II standard will produce overall minimum risk-based regulatory capital requirements that exceed the capital necessary to maintain a rating of “adequately capitalized” under current Prompt Corrective Action (PCA) regulations that were mandated by the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).

My testimony will focus on how Basel II can be adopted and eventually implemented in the U.S. given the concerns raised by QIS-4. I will focus on the importance of the relationship between the Basel II standards and the PCA regulations, specifically our existing U.S. leverage requirements. My testimony will argue that the QIS-4 results reinforce the need to revisit Basel II calibrations before risk-based capital floors expire and to maintain the current leverage ratio standards. Leverage requirements are needed for several reasons including:

• Risks such as interest-rate risk for loans held to maturity, liquidity risk, and the potential for large accounting adjustments are not addressed by Basel II.

• The Basel II models and its risk inputs have been, and will be determined subjectively.

• No model can predict the 100 year flood for a bank's losses with any confidence.

• Markets may allow large safety-net supported banks to operate at the low levels of capital recommended by Basel II, but the regulators have a special responsibility to protect that safety-net.

Source: FDIC calculations based on QIS-4 data.

For each QIS-4 organization we estimated total insured bank tier 1 capital requirements to be well capitalized under U.S. risk-based capital regulations under Basel II and under current risk based requirements. The insured bank share of QIS-4 risk-weighted assets (RWA) is estimated as total insured bank RWA divided by total Y-9 RWA, using current capital rules, at the report date. Insured bank tier 1 capital requirement to be well capitalized is 6 percent of estimated insured bank RWA, plus the insured bank share of any reserve shortfall if such a shortfall was reported.

If the total insured bank tier 1 risk-based capital requirement for an organization, estimated in this way, exceeds 5 percent of average total insured bank assets for that organization, the organization is slotted in the "well capitalized" row. If this risk-based requirement is between 4 and 5 percent of assets, the organization is slotted in the "adequately capitalized" row. If the risk-based requirement is between 3 and 4 percent of assets, the organization is slotted in the "undercapitalized" row. If the risk-based requirement is between 2 and 3 percent of assets, the organization is slotted in the "significantly undercapitalized" row. Finally, if the risk-based requirement is less than 2 percent of assets, the organization is slotted in the "critically undercapitalized" row.

In other words, under the Basel II framework as currently fashioned, the leverage ratio will become the effective, binding minimum capital standard for most large U.S. banking companies. While we are aware that minimum regulatory capital requirements can constrain bank equity returns, we are not aware of any public policy studies or other claims that the current level of regulatory capital requirements is a barrier for the provision of additional banking services that are beneficial for the public. In the FDIC's view, Basel II should be calibrated in a manner that ensures that, for most banks in most circumstances, the overall minimum risk-based capital requirements (credit, operational and market risk) exceed the minimum leverage capital requirements that are currently set in FDICIA and its implementing regulations.

In terms of the capital impact of an up-and-running Basel II, if the present framework remains unchanged, the FDIC's analysis suggests that the future will bring even greater declines in capital requirements than are suggested by QIS-4. As described in Appendix B, the risk inputs of banks for QIS-4 purposes appear on average very conservative, more so than a strict reading of the framework would require. Moreover, the QIS-4 declines in required capital are achieved without fully factoring in capital reductions that can be achieved using credit risk hedges and third party guarantees under a fully implemented Basel II standard. These additional factors could generate significant reductions in capital requirements beyond those that were identified in the QIS-4 results. The FDIC does not believe that there is adequate support for the agencies to conclude that the capital reductions that likely will result from the current Basel II framework are commensurate with the reductions in the investment risk exposures of banks that will be engendered by improvements in risk management occurring under Basel II. Indeed, unless it can be demonstrated that Basel II will substantially reduce banks' credit risk exposure profiles, the increase in allowed leverage could easily lead to higher system-wide risks.

Even if there were no leverage requirement and no PCA regulations, the FDIC would find the capital requirements coming out of QIS-4 to be too low for many reporting institutions. Banks operating with the benefit of a federal safety net have operated at such capital levels for a time, but ultimately at a great cost to that safety net. In part because Basel II can be expected to generate such low capital requirements, the leverage ratio will play a more important role than ever in protecting the insurance funds.

In the view of the FDIC, the leverage ratio is an effective, straightforward, tangible measure of solvency that is a useful complement to the risk-sensitive, subjective approach of Basel II. The FDIC is pleased that the agencies are in agreement that retention of the leverage ratio as a prudential safeguard is a critical component of a safe and sound regulatory capital framework. The FDIC supports moving forward with Basel II, but only if U.S. capital regulation retains a leverage-based component.

Expectations for Insured Banks under Basel II

The federal safety net in the U.S. extends explicitly to insured banks, not their holding companies. The absolute accountability of insured institutions for their own governance, and for maintaining an adequate level of capital, is of fundamental importance in controlling the potential cost of that safety net. That is why a critical element for the success of Basel II as a safety-and-soundness initiative is maintaining appropriate expectations for insured banks.

In concrete terms, insured banks that adopt Basel II will need to calculate and report a capital requirement that is appropriate for their own risk exposures. Capital reductions derived from diversification of exposures held in separate legal entities may prove to be only hypothetical should one of the entities become undercapitalized on a stand-alone basis. This does not mean that holding companies will need to maintain separate and duplicative Basel II infrastructures at every insured subsidiary. Indeed, to the extent that regulators expect the accurate measurement of risk at the holding company level, that would seem to require compatible systems at all subsidiary legal entities. In terms of managing and controlling the government's deposit insurance exposure, however, effective risk control requires that capital calculations be geared to the unique risks and exposures of each insured subsidiary.

Transparent Information—Ongoing Analysis Required

The FDIC is committed to transparency, and it is our belief and expectation that the banks and their primary federal regulators will collaborate and share information in a manner that allows each agency to address its concerns with regard to the new capital framework. As outlined above, the QIS-4 study indicates that modifications of the current Basel II framework are likely to be necessary to ensure that regulatory standards require adequate bank capital and equal capital is required for equal risk. In order to reach a prudent judgment regarding the safety and soundness implications of any such proposed changes and to ensure a level playing field within the U.S., the FDIC and the other banking regulatory agencies must obtain adequate information regarding all participating banks' internal credit risk modeling systems and resulting minimum capital requirements. From the FDIC's perspective of assessing risks to the insurance funds, collaboration must include access to information about the critical assumptions, models and data used to implement capital requirements based on banks' own estimates of risk.

Competitive Equity—Basel IA Advance Notice of Proposed Rulemaking

Throughout the Basel II process, the FDIC has expressed concerns about the potential detrimental effects that the new framework could have on competition within the U.S. banking sector. Indeed, the QIS-4 results suggest that the competitive ramifications could be profound. Absent modifications to the current and proposed risk-based capital frameworks, the FDIC believes that the non-Basel II banking sector could be placed at a competitive disadvantage to larger banks subject to the Basel II framework. To address these concerns, the agencies have issued an Advanced Notice of Proposed Rulemaking to begin the process of developing an alternative for non-Basel II adopters (Basel IA ANPR).

The Basel II banks already enjoy a pricing advantage over their smaller competitors due to their asset size, underwriting volume, and related economies of scale. However, this pricing advantage could be magnified by the reduced risk-based capital requirements of Basel II. The higher capitalized non-Basel II banks may become more attractive acquisition targets for Basel II adopters. Further, the results of the QIS-4 exercise show that the advantage of the Basel II framework could be the greatest in those areas where credit risks historically have been the lowest.

Under the Basel II framework, capital requirements for residential mortgages, home equity loans, and similar exposures drop significantly. For example, risk-based capital requirements for single-family residential mortgage exposures fall from 4 percent under current Basel I standards to 1.5 percent under Basel II (based on the average risk-weight reported in QIS-4). Moreover, Basel II, as seen in the QIS-4 results, greatly expands the disparity in minimum required risk-based capital between lower risk and higher risk credits. For example, prime mortgages will receive a much lower capital charge than subprime mortgages under Basel II. In contrast, prime mortgages and subprime mortgages are generally assigned to the same risk weight category under existing risk-based capital rules. It is reasonable to assume that there will be a similar disparity between capital requirements for prime and subprime credit card exposures. As a result, without mitigating changes to the competing frameworks, non-Basel II banks could be placed at a severe competitive disadvantage to Basel II banks in prime-grade markets while possibly gaining a competitive advantage over Basel II banks in subprime markets. The end result of such disparate capital treatments could be a migration of high risk credits away from Basel II banks and towards non-Basel II banks. We must monitor this potential change very carefully from a safety and soundness perspective as well as monitor changes in the exposure of the insurance funds.

In order to advance a full dialogue of the competitive concerns associated with changes to the capital framework, the agencies issued the Basel IA ANPR that outlines potential changes to risk-based capital regulations for all U.S. banks. The agencies are soliciting comments on how to achieve greater risk sensitivity for capital in a way that does not create undue burden for insured institutions and is consistent with safety and soundness objectives.

The FDIC is aware that competitive equity concerns are not the same for all banks. Some community banks choose to maintain large amounts of risk-based capital—not because they operate in a risky manner, but rather because they have lower risk appetites or tolerances. Therefore, we are requesting comments in the Basel IA ANPR concerning the possibility of allowing these types of institutions to opt out of proposed changes.

In addition to addressing potential competitive inequities and recognizing industry advances in credit risk measurement and mitigation techniques, the Basel IA ANPR will also propose ways to modernize the risk-based capital rules for all U.S. banks. Key components of the ANPR ask for comment on:

• Increasing the number of risk-weight categories for bank credit exposures.

• Expanding the use of external credit ratings as an indicator of credit risk for externally rated exposures.

• Expanding the capital reductions available from the use of collateral and guarantors.

• Adopting loan-to-value ratios and credit score measures to assign risk weights to residential mortgages.

We believe that most, if not all, of these proposals can be applied using information that is readily available to banks. However, we have asked for comment on whether the trade-off of a more risk-sensitive capital framework is justified by any possible burden generated by its implementation.

Finally, we are asking for comment on any concerns not addressed by the agencies in the ANPR. The FDIC is confident that by listening to the needs and concerns of the banking community and other commenters, a revised capital framework can be put in place for non-Basel II banks that will mitigate many of the competitive equity concerns.

Conclusion

Going forward, the FDIC plans to issue the Basel II NPR, and coordinate its issuance with a Basel IA Notice of Proposed Rulemaking (this will follow the ANPR) in a manner that will allow for some overlap in the comment period for the two notices of proposed rulemakings. This process will allow the two proposals to be compared side-by-side so that the public can fairly determine the possible competitive implications of the overall package of proposed changes to U.S. capital regulation.

We are working diligently to ensure that, as originally envisioned, the new regulatory capital framework articulated by Basel IA and Basel II enhances the safety and soundness of the U.S. banking system. The U.S. agencies must continue to work closely together, share information, reach conclusions on important changes to the proposed framework, and re-assess the impact of any such changes. The FDIC is working with the other agencies to develop a framework that achieves this broad objective and preserves a set of straightforward minimum capital requirements to complement the more risk-sensitive, but also more subjective, approaches of Basel II. We also want to maintain competitive equity and achieve results under Basel II that are less extreme and more consistently applicable across banks.

The FDIC, like the other banking agencies, will proceed with the implementation of Basel II in an appropriately deliberative manner and with full consideration of the comments of all interested persons.

Appendix A
Appendix A - PDF 23k (PDF Help)

Appendix B
Appendix B - PDF 30k (PDF Help)