Speeches & Testimony
Donald E. Powell Chairman
Federal Deposit Insurance Corporation on
the Development of the New Basel Capital Accords
Before the Committee on Banking, Housing, and Urban Affairs.
November 10, 2005 -- 9:30 AM
538 Dirksen Senate Office Building
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
change in capital regulation for our largest banks. Basel II clearly
requires a more sophisticated approach to risk measurement by the adopting
At the same time, however, the most recent quantitative impact study,
QIS-4, showed both a very large reduction in capital requirements for
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
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.
Under the current formulation of Basel II, the leverage ratio standard
will be more important than ever in guarding against losses to the
insurance funds resulting from insufficient capital at the individual
bank and the industry level.
Explaining the QIS-4 Results—Concerns Continue
Following a preliminary analysis of the QIS-4 results completed in
April, the agencies sought to determine the reasons for the significant
declines in required capital levels and dispersion in reported results.
Comprehensive analysis was needed to determine whether QIS-4 anomalies
reflect actual bank differences in risk, limitations in the design
and implementation of the QIS-4 study, variations in the stages of
bank implementation efforts (particularly related to data availability),
or whether the QIS-4 results indicate the need for adjustments to the
Basel II framework.
The agencies are not yet in a position to publish a comprehensive
summary of our analysis of the QIS-4 results. The agencies have, nevertheless,
determined that the QIS-4 results were driven to varying degrees by
all of the aforementioned factors. As was envisioned in the design
of Basel II, QIS-4 results show that the amount of required regulatory
capital does vary with the risk characteristics of individual exposures.
In many cases, however, variation in reported capital requirements
had more to do with differences in banks' risk measurement methodologies,
or the degree of their adherence to Basel II requirements as provided
in the QIS-4 instructions, than with true differences in risk. In the
design of QIS-4, the regulators did not intend to be prescriptive about
how banks measure their own risk and recognized that the Basel II framework
itself allows for considerable variation in capital requirements for
In addition to the observed capital variation that reflected differences
in banks' internal risk assessments, the FDIC's analysis
suggests that much of the observed reduction in capital requirements
under QIS-4 is built into Basel II's formulas. That is, the regulatory
capital formulas in Basel II are inherently calibrated to produce large
reductions in risk-based capital requirements. Better data, or better
compliance by Basel II banks with the standards required by the framework,
would not in this view mitigate the large reductions in capital requirements
suggested by QIS-4. If anything, QIS-4 may understate the reductions
in minimum capital requirements that would ultimately be expected under
an up-and-running Basel II.
Exhibits 1-3 in Appendix A provide a sense for the drop and dispersion
of capital requirements suggested by QIS-4. At many institutions, the
QIS-4 results show significant reductions in risk-based capital. The
Exhibit 1 table indicates the total minimum capital requirement of
all participating banking organizations falls by an aggregate of 15
percent. Capital requirements declined by more than 26 percent in more
than half of the banking organizations in the study.
Basel II sets capital requirements for selected portfolio groupings
(e.g., wholesale commercial and industrial, retail, real estate development,
etc.). At the portfolio level, the Basel II capital requirements for
most portfolio groupings decreased substantially across participating
banking organizations. Most organizations reported double digit declines
in capital requirements for most loan portfolios, with only a few portfolio
categories posting increases (notably credit card exposures). For example,
Exhibit 1 indicates that capital requirements for wholesale loans declined
by 25 percent on average at the subject banking organizations. Capital
requirements for so-called high volatility commercial real estate loans
fell by 33 percent, while capital requirements for other commercial
real estate loans fell 41 percent. Capital requirements for small business
loans fell by 27 percent. Capital requirements for mortgage and home
equity loans fell by 61 and 74 percent, respectively.
In addition to problems resulting from the significant decline in the
level of regulatory capital, concern persists over QIS-4 results showing
an inconsistency in the capital results for similar risks across institutions.
The Exhibit 2 and 3 charts show the wide variation in capital requirements
around the averages reported in Exhibit 1. Further, in a sample of
large corporate credits that had identical lending relationships with
many of the QIS-4 institutions, individual banking organizations reported
changes in minimum capital requirements that varied widely. Using the
QIS-4 results of a single reporting institution to set a benchmark
of comparison, QIS-4 participants reported minimum capital requirements
for these identical credits that ranged from 30 percent less to190
percent greater than the benchmark bank's calculation. For representative
mortgage products, banking organizations reported risk weights that
ranged from 5 percent to 80 percent on identical exposures. These results
suggest that QIS-4 differences in minimum capital requirements are
not entirely explained by true risk differences in bank products. Rather,
a substantial source of the variation in Basel II capital requirements
can be explained by differences in the risk inputs that individual
organizations assign to identical exposures.
Overall, the QIS-4 study confirms that the regulatory capital requirements
set by the Basel II framework are very sensitive to individual banks' subjective
assessments of risk. Achieving consistency in Basel II currently hinges
on the hope that industry best practices and better data will lead
to reduced dispersion in the capital treatment of similar loan portfolios
across banks. At present, however, the QIS-4 results show that there
is little commonality in the approaches the various banks are using
to estimate their risk inputs. While this inconsistency may, in part,
be corrected with refinements to internal systems and through improved
regulatory guidance, differences are also inherent in the proposed
framework and suggest the need for adjustments and safeguards going
Notice of Proposed Rulemaking Will Set Forth Additional Prudential
The U.S. agencies intend to publish a Notice of Proposed Rulemaking
on the U.S. implementation of Basel II during the second quarter of
2006 (Basel II NPR). The Basel II NPR will propose an advanced internal
ratings-based approach that includes additional prudential safeguards
designed to address the QIS-4 results. These safeguards include:
limit on the amount by which an institution's risk-based capital
may decline as a result of Basel II. These floors
will be retained
for a minimum three year transition period and established at 95
percent the first year, 90 percent the second year, and 85 percent
• The release of floors only upon approval of an institution's
primary federal regulator.
• Continuing evaluation of revisions to the framework
given actual experiences over the transition period.
• The retention of existing PCA standards, including the
existing leverage ratio standards.
The FDIC continues to emphasize the importance of maintaining a minimum
capital standard embodied in a leverage ratio. The Basel II standard
is not intended to provide capital for all material risks. For example,
the interest rate risk associated with most loans that banks hold to
maturity, liquidity risk, and business risks such as the potential
for large accounting adjustments, are not factored into the Basel II
framework. Moreover, the framework relies on individual bank risk exposure
estimates that are, by their nature, prone to inaccuracy. Further,
these estimates are input into a regulatory model that is only a simplified
expression of the actual risks retained by large complex banking institutions.
These model risks, that are inevitable when banks are required to estimate
their own risk inputs for a simplified regulatory capital model, may
lead to inadequate regulatory capital requirements under the Basel
Retaining the existing leverage ratio, a simple and effective standard,
is an important pillar of the safety and soundness regime. The importance
of the leverage ratio is highlighted by recent analysis conducted by
the FDIC that draws upon the QIS-4 results. This analysis shows that
under the current Basel II framework, the leverage ratio will serve
a more important role than ever in ensuring that adequate levels of
capital are maintained throughout the system.
Basel II and PCA: An Impending Conflict of Expectations
The FDIC has analyzed how the Basel II standard would compare to U.S.
capital standards currently applicable to insured institutions. We
found that as a set of quantitative capital standards, Basel II appears
to lower the bar considerably compared to current U.S. leverage and
risk-based capital standards embodied in the agencies' PCA regulations.
The QIS-4 exercise was conducted at the consolidated bank holding company
level. QIS-4 does not quantify the minimum regulatory capital levels
that may prevail under Basel II at the individual banks that participated
in the study. Moreover, the capital requirements reported in Charts
1-3 in Appendix A are for total capital, which includes elements such
as loan loss reserves, subordinated debt and certain intangible assets
that do not provide the same level of protection to the insurance funds
as does core, or tier 1, capital. To better quantify the issues that
are most directly relevant to the FDIC as insurer, we therefore estimated
the tier 1 capital requirements that would apply at the 74 insured
banks that are subsidiaries of the 26 QIS-4 reporting organizations.
Details on this estimation methodology are provided in Appendix B.
Analysis of the QIS-4 data completed by the FDIC shows that Basel II
produces minimum regulatory capital requirements that are unacceptably
low under the existing PCA standards implemented pursuant to FDICIA.
Using QIS-4 data, our analysis reveals that—should the leverage
ratio be removed under Basel II—the majority of QIS-4 institutions
would be less than adequately capitalized (i.e., under-capitalized,
significantly under-capitalized, or critically under-capitalized) if
they held only the level of capital generated by the Basel II formulas.
As shown in the table on the next page, if the Basel II standards are
the only constraint on the banks' minimum levels of capital,
the majority of 26 banking companies participating in the QIS-4 study
could fall to levels currently considered less than adequately capitalized
under the PCA standards; that is, the minimum regulatory capital of
these institutions would fall below the 4 percent leverage ratio.
|Basel II Conflicts with Existing Prompt Corrective Action (PCA) Capital Standards
|(Tier 1 risk-based capital requirement versus leverage PCA requirement for 26 QIS-4 banking organizations)
||Number of banks in PCA leverage category based on risk-based capital requirements
|Leverage PCA Category
||Basel II risk-based
|Total Number of QIS-4 Banks:||26||26|
|*Substituted tier 1 risk-based capital requirement for tangible equity capital requirement.|
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.
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
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
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
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
the number of risk-weight categories for bank credit exposures.
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
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.
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
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 - PDF 23k (PDF Help)
Appendix B - PDF 30k (PDF Help)