| August 18, 2003
Basel Committee on Banking Supervision
Bank for International Settlements
2 Centralbahnplatz
CH-4002, Basel, Switzerland
Re: The Proposed New Basel Capital Accord
Wells Fargo & Company appreciates the opportunity to participate in
the ongoing dialogue on the Basel capital reform proposal. We are a
diversified financial services company, providing banking, insurance,
investments, mortgage and consumer finance from more than 5,600 stores,
as well as through the Internet and other distribution channels across
North America. As such, we have a keen interest in the framing of the
Basel Accord and hope that the comments that we offer in this paper will
be of assistance in providing solutions to the issues that exist in the
current proposal.
Sincerely,
Howard Atkins
Wells Fargo, San Francisco, CA
cc: Basel 2003 Capital Proposal
Ms. Jennifer J. Johnson, Secretary
Board of Governors of the Federal Reserve System
20th Street and Constitution Avenue, NW
Washington, DC 20551
Basel 2003 Capital Proposal
Office of the Comptroller of the Currency
Communications Division
Third Floor
250 E Street, SW
Washington, DC 20219
Mr. Robert E. Feldman, Executive Secretary
Attention: Comments
Federal Deposit Insurance Corporation
550 17th Street, NW
Washington, DC 20429
Wells Fargo & Company appreciates the opportunity to participate in
the ongoing dialogue on the Basel capital reform proposal. While we
respect the tremendous amount of time and effort that has gone in to
shaping the proposal, we find that we still have some fundamental
differences of opinion with the path on which the Basel Committee is
proceeding and feel that certain aspects of the proposal must be changed
in order for it to be acceptable.
We will restrict our comments to the Advanced IRB approach to Credit
Risk and the Advanced AMA approach to Operational Risk within the Basel
proposal, since those modules are now the focus of the banking
regulators in our jurisdiction. We will also allude to certain aspects
of the apparent implementation plans for the Accord, as publicized by
the U.S. banking supervisors, although we recognize that such plans are
being undertaken solely at their discretion and are not being dictated
by the Basel Committee. Nevertheless, we feel that it is important to
comment on supervisory actions that are permissible within the context
of the proposed Accord.
We expect that there will be a relatively uniform set of concerns
that are communicated to the Basel Committee with respect to
Consultative Paper 3 - excessive conservatism, undue prescriptiveness,
questionable treatment of expected losses and the loan loss reserve in
the capital calculations, and inadequate recognition of risk mitigation
actions, to name a few. We share and support these concerns, and will
offer similar comments in the course of this letter.
However, these issues relate primarily to the risk-based capital
calculation itself. In the final analysis, this calculation is not
critical to Wells Fargo, insofar as our pricing decisions are based not
on regulatory capital, but rather on internal economic capital analyses.
Moreover, we are convinced that, if any risk-weighting concessions are
granted by the Basel Committee in reaction to the comments received on
the Consultative Paper, they will shortly thereafter be reclaimed
through a new calibration of the risk-weighting formulas present in
Pillar 1, or through different Pillar 2 requirements. How else will the
Basel Committee manage to keep the overall level of capital in the
banking system unchanged, particularly if the only banks in the U.S.
that are subject to the Accord will be those with a tendency toward
diminished capital requirements under the new system?
Therefore, the primary points that we will emphasize, and where we
feel that we must be successful in helping the Basel Committee and the
U.S. regulatory authorities implement a more appropriate regulatory
capital regime, are in those areas where we believe that the Accord has
ventured beyond its intended scope.
1. First and foremost, we believe that the Accord has become
entirely too prescriptive and inflexible in its vision of the risk
management processes to which banks must adhere. This is in stark
contrast to the original supposition of Basel II -- that each bank
would be allowed to continue the use of its existing risk management
practices, so long as they could be shown to have been effective over
time. The Accord should only aspire to establish a more risk-sensitive
framework for constructing minimum bank regulatory capital
requirements. It cannot, and should not, attempt to dictate how banks
actually manage risk. For those institutions, like Wells Fargo, with
proven risk management processes in place, it would be imprudent, and
perhaps dangerous, for them to make significant changes to their risk
management systems in the absence of quantifiable and validated data
that clearly demonstrates that an alternate system is more robust and
accurate, and could be successfully inculcated into their risk
management process. Does the Basel Committee really intend to force
the migration of well-functioning, customized risk management
processes into an untested, complex framework with the potential to
actually confuse, or undermine, the control and understanding that
banks currently have of their credit portfolios?
2. The decision of the U.S. banking regulators to require only 10
U.S. banks to comply with the Accord increases the likelihood of
creating an uneven playing field for major competitors in the U.S.
financial services industry. Wells Fargo is large. However, our
credit portfolios, customers, and risk profile more closely resembles
that of smaller regional and community banks than larger,
internationally-active, money center institutions. The deliberate
creation of a bifurcated capital regime sets the stage for instances
where direct competitors will not be subject to the same capital
standards. It is likely that these inequities be particularly
meaningful to those institutions, like Wells Fargo, that are widely
diversified by line of business and geography and, consequently, faced
with a wider variety of smaller, heterogeneous competitors.
3. The Pillar 3 disclosure requirements of the Accord remain
overly prescriptive, inappropriate, and unnecessary. We believe
that the Pillar 3 requirements are not appropriate because public
disclosure requirements ought to be set solely by those agencies that
safeguard the interests of investors (i.e., the SEC, the FASB, and the
rating agencies), not by banking supervisors who have neither the
responsibility, the focus, nor the expertise to take on that role.
Furthermore, such requirements seem unnecessary to us, because, quite
outside of Basel, the market will dictate those elements of bank risk
management disclosure that are most necessary to improve transparency.
We feel compelled to raise these issues, and others that we will
enumerate, not only because they are important to us, but because we are
concerned that the support that may exist for the Basel proposal within
the banking community today stems not from a philosophical agreement
with the direction of the Accord, but either from the fact that many may
view the Accord as a fait accompli and are "jumping on the bandwagon"
or, more narrowly, from the standpoint of whether or not a particular
bank anticipates that it will receive a lower regulatory capital
requirement under the new system. After all, if one accepts that all
banks are, in principle, trying to maximize return on internal economic
capital, subject to the constraint that economic capital be less than
regulatory capital (in total), then regulatory capital becomes
inconsequential to the risk/return proposition, except for the fact that
banks will always argue for a less binding constraint (that is, lower
regulatory capital). With Basel II, there is a further consideration in
this equation, in terms of the considerable compliance costs that the
Accord will impose on the banking system, an additional sunk cost
without compensatory return.
THINGS THAT NEED TO BE CHANGED
Flexibility for National Banking Supervisors to Dictate
Operational Details of Bank Risk Management -- The language of the
Accord is, in fact, quite contradictory in and of itself on the topic of
the extent to which specific operational aspects of risk management
would be mandated. In describing the minimum requirements for the IRB
approach, paragraph 351 of the Consultative Paper states the following:
"The [Basel] Committee recognizes that differences in markets, rating
methodologies, banking products, and practices require banks and
supervisors to customize their operational procedures. It is not the
Committee's intention to dictate the form or operational detail of
banks' risk management policies and practices. Each supervisor will
develop detailed review procedures to ensure that banks' systems and
controls are adequate to serve as a basis for the IRB approach." And,
yet, the next 50 paragraphs of the Consultative Paper itemize in detail
the operational policies that the Basel Committee deems "best practice"
and required for certification.
It is primarily in this area of the proposal that we have identified
several specific requirements that need to be eliminated as requirements
or significantly modified:
1. Paragraph 386 states that "ratings assignments and periodic
rating reviews must be completed or approved by a party that does not
directly stand to benefit from the extension of credit."
Our view on the credit approval process is 180-degrees opposed to
this perspective. Wells Fargo employs an Expert Judgment rating
process for wholesale credits, where lending officers are responsible
and held accountable for maintaining accurate and timely risk ratings.
They are the principal owners of the risk ratings. The requirement of
ownership is probably the most important aspect of our credit culture.
We believe that lending officers need to know their customers, monitor
their customers' financial condition and collateral, and surface
deteriorating situations and problem loans early. The requirement and
expectation that lending officers own the risk rating, and are
responsible for the risk rating, forces them to meet our management's
expectations with respect to the credit process; that is, properly
underwriting, analyzing, and monitoring their credits. This
fundamental pillar of our credit culture is augmented by a strong,
independent loan review function (called Risk Asset Review) that
evaluates each office's lending practices and has final authority on
the risk ratings assigned.
Now, we are being told that we must change our risk rating system
to conform to some theoretical, yet unproven, new system, even though
we have had one of the best credit quality trends in the industry. We
are not an internationally active bank. Our credit extensions are
neither exotic nor complex. 95% of our commercial loans outstanding
are to middle market and small business customers. Judgments by
talented and experienced lending officers and credit supervisors are
particularly important for these types of customers, as compared to
the analysis of loans to large corporations. To shift the
responsibility for assigning wholesale lending risk ratings to an
independent rating function seems totally implausible to us. This
would be like asking an auditor to audit a system that has been
developed and implemented by auditors. We strenuously object to
regulatory efforts to disrupt successful risk management cultures,
such as ours, that have been developed through years of training and
practice, with proven results. The Accord should be re-worded to
exclude this directive.
2. Paragraph 386 goes on to state that "independence of the rating
process can be achieved through a range of practices that will be
carefully reviewed by supervisors."
Based on this language in the proposal and discussions that we have
held with our national banking supervisors, we believe that our
banking supervisors will require someone besides the lending officer
to sign-off on every rating decision made by the lending officer. This
idea is not only ludicrous from a cost/benefit standpoint, but it
would also, over time, have a significant adverse impact on our credit
culture; that is, the notion that lending officers own the risk
ratings. The Accord should be re-worded so that it does not permit
such an interpretation of its design.
3. Paragraph 403 states that "banks must have independent credit
risk control units that are responsible for the design or selection,
implementation and performance of their internal rating systems. The
units must be functionally independent from the personnel and
management functions responsible for originating exposures."
With respect to retail portfolios, we have much the same philosophy
as expressed in our earlier comments on rating wholesale credits. We
believe in assigning responsibility for the credit modeling and risk
assessment functions to those areas that are expert in the relevant
product development and customer servicing. While we do distinguish
the marketing and credit approval responsibilities within these
business units, we feel that it is critical to hold them accountable
for the full P&L impact of their credit decisions. As with our system
of wholesale checks and balances, we have a strong loan review
function (Risk Asset Review) that examines the accuracy with which
Bank risk rating policies are followed among retail lending units.
Paragraph 403 should be re-worded to eliminate the concept of
functional independence of credit risk control units.
4. We are highly skeptical that the data maintenance standards for
the advanced IRB outlined in Paragraphs 391 to 395 constitute "best
practice." Notwithstanding the language of Paragraph 351, it appears
possible that Paragraph 391 may be interpreted by our national banking
supervisors in such a way that they may impose detailed data
warehousing requirements on Expert Judgment risk rating systems of
Advanced IRB banks. The apparent goal of such requirements would be to
validate not only the accuracy of PD and LGD estimates made from a
bank's rating system at the "back-end" of an account's life cycle
(which is understandable), but also the accuracy of the account's
initial risk ratings through an Evaluation of Developmental Evidence
at the "front-end" of its life cycle.
We are unaware of any form of front-end "validation" of either
judgmental or modeled risk ratings that has been demonstrated to have
any statistical power in use anywhere in the financial services
industry, so we have a basic question about the underlying objective
for the supervisory expectations regarding data maintenance. And, if
such interpretive data maintenance standards are a precursor to the
required development of credit scoring models for large wholesale
credits, our experience over the years in credit evaluation has taught
us that over-reliance on credit scoring models for the type of lending
that we do could produce disastrous results. We believe that such an
approach would actually increase risk in the banking system.
The Accord should be re-worded such that the data maintenance
standards contained in Paragraphs 391 to 395 are not interpreted as a
universal requirement of the Accord, but rather as a principle to be
followed by banks wishing to investigate credit scoring models as
"challengers" to the rating systems that they currently have in place.
Our experience with such models, which is admittedly more in the area
of retail credit risk management, is that such models take 3 to 5
years to build and test to the point where one would be willing to
accept their results.
5. We are also apprehensive that the language of the Consultative
Paper may be interpreted by banking supervisors in such a way that a
certain specificity of risk rating definitions is prescribed to banks.
Although Basel II allows for an Expert Judgment system, discussions
with our national banking supervisors have led us to believe that they
will require banks to identify and track specific criteria for
each
factor that is considered in a rating decision. This will be required
to achieve "transparency" of a rating system. However, by dictating
such a requirement, the national banking supervisors will, in effect,
have eliminated Expert Judgment systems as a risk rating practice and
imposed Constrained Judgment systems in their place.
Such interpretive rulings would not represent principles of sound
risk management that are unilaterally applicable. They would be
prescriptions, pure and simple. We note, with interest, that the U.S.
banking regulators, themselves, have not followed these prescriptions
when articulating the risk rating scale on which their Shared National
Credit examinations will be conducted in the future. We are adamantly
opposed to this form of capital regulation. The Accord should be
re-worded to exclude the possibility of such supervisory
interpretations of risk rating definitions.
6. We are fearful that certain concentration limits may be imposed
by our national banking supervisors on the fraction of a portfolio
that can be present in any one risk rating classification (without
regard to the nature of the business being conducted).
Again, such interpretive rulings would simply be prescriptions, in
the absence of any evidence that a bank's risk rating scale is
obscuring the timely identification of risk in the portfolio. The
scope and diversity of a bank's lending practices should be the
ultimate determinant of the distribution of its portfolio across risk
rating classifications; there are no arbitrary targets for this
distribution. The Accord should be re-worded to exclude the
possibility of isolated supervisory interpretations of credit
concentrations.
There is nothing inherently wrong with any of the systems proposed by
the Basel Committee and our national banking supervisors. Each may be an
appropriate rating system given certain circumstances, such as the
nature of a particular bank's business or the state of a company's
credit culture. However, Wells Fargo has operated successfully for many
years with its current Expert Judgment rating system. This is confirmed
not just by our financial results, but also by the fact that independent
third parties (principally, our national banking supervisors and rating
agencies) have consistently concluded that Wells Fargo has a sound
credit risk management process, a rating system that rank orders risk,
and a rating system that is accurate.
Wells Fargo would be doing a disservice to its shareholders and
debtholders if it did not defend the risk management practices that have
operated so successfully for the Bank over the years. We strongly
encourage the Basel Committee to reconsider some of the points that we
have made above, to remove some of the regulatory prescriptiveness
relative to the operational detail of bank risk management policies and
practices, and to allow banks like Wells Fargo to preserve
well-functioning credit cultures that they have developed.
Competitive Equality - Our second primary issue with the
Accord deals with the scope of its application. Recently, the U.S.
banking regulators decided that only 10 U.S. banks must comply with the
Accord. We believe that this decision increases the likelihood of
creating an uneven playing field for major competitors in the U.S.
financial services industry. Activities that, we feel, receive
particularly onerous treatment in the Accord, such as retail lending and
operational risk (e.g., transaction processing and asset management),
would gain an undue advantage when offered outside of the Accord, either
by non-bank competitors or other large banks.
Although we have not seen a list of the 10 mandatory "Basel Banks" in
the U.S., we estimate that many of the institutions that we compete with
most directly in our various regional markets may not be subjected to
Basel's strict compliance standards and costs. Wells Fargo competes
directly against smaller regional and community banks within the
geographic footprint in which our respective banking franchises operate,
yet they would not be subject to the same capital standards simply
because they do not have the same scale of business as we do outside
of this geographic footprint, but within the U.S. A number of banks that
are as large or larger than Wells Fargo in terms of particular product
lines, but smaller than our Bank in terms of total assets, would not be
subject to the same capital standards merely because they are not as
diversified as we. Other examples of potential competitive inequality
include monoline non-bank competitors in the credit card and retail
lending business, as well as some of the largest institutions offering
personal and institutional asset management. Across the sphere of
diversified financial services that Wells Fargo offers, there will be
meaningful instances where our direct competitors will not be taxed to
the extent that we will be, simply because they do not enjoy the
business diversity and economies of scale that we do.
With respect to competition, our contention would be that size
is not the same as risk, and that an arbitrary measure like total
assets is not the only, or best, way to measure either size or risk. The
only fair way to enforce the Basel standards is to apply them to all
banks, using the full range of options (Standard, Foundation, Advanced)
that Basel envisions. If the U.S. regulators deem it necessary to impose
the Advanced IRB (A-IRB) approach to Credit Risk on the largest U.S.
banking institutions, in light of credit risk being the predominant risk
that banks undertake as a matter of course, we believe that in order to
lessen the competitive equality issues, the managed asset size threshold
for mandatory A-IRB compliance should be reduced so as to include the
top 50 U.S. banks, and that smaller banks should be required to adopt
either the Standard or Foundation approach. While such a bifurcated
system might result in higher credit capital requirements for smaller
banks, it is the smaller banks that historically have had the greatest
frequency of failure and the less-developed risk management processes.
This approach is the only way, we feel, to adequately address both
competitive equality and safety and soundness considerations.
In contrast, because there is no accepted methodology for quantifying
Operational Risk, we also believe that the AMA approach to Operational
Risk should not be the sole option that is made available to U.S. banks.
We will expand on this thought in our commentary below that is specific
to Operational Risk.
Pillar 3 - The final area in which we believe that the Accord
has ventured beyond its intended scope is Pillar 3. The proposed Accord
requires that a bank make extensive disclosures about its risk profile
and risk management processes. We view the proposed requirements for
Pillar 3 disclosure as excessive and costly to implement, with the
resulting information being potentially confusing to the investment
community, particularly with respect to efforts to compare the risk
profile of one institution to another. Rather, we feel that market
forces can act as a better policing authority for required disclosures,
compelling companies to achieve a requisite level of transparency on
topical issues. We believe that the proposed approach is flawed on
several counts:
• First, we see no basic need for such disclosures. The market is
sufficiently well informed already, as evidenced by the breadth of
banks' securities issuance activities. Securities transactions require
the market to constantly assess a financial institution's
creditworthiness, risk profile, and capital structure. If the market
needs more information in order to perform this assessment, it will
demand it; and, it will penalize the reputation of those that cannot
provide the necessary information. We do not believe that the Basel
Committee can effectively, nor should it, determine the informational
requirements of bank credit markets.
• Second, efforts to employ disclosures such as those proposed in
order to make comparisons in the risk profiles of two financial
institutions will invariably lead to misinterpretations among readers
of the information. We know well from our considerable experience in
acquiring other banks how different two banks' approaches to risk
rating loans can be. Without exception, we have come away from the due
diligence efforts on potential acquisition candidates planning for the
changes that we will have to make to the target company's reporting of
its risk profile in order to make it comparible to our more
conservative approach. This same issue will extend to a comparison of
Probability Of Default, Loss Given Default, and other metrics across
institutions, as each company will take a different approach to its
parameter estimation process.
• Third, the Pillar 3 disclosure requirements may be duplicative
to, and potentially inconsistent with, existing or future GAAP and
non-GAAP accounting disclosures, and unnecessarily costly to compile
and report within adequate standards of audit controls. We view the
potential for lawsuits as being very high, and regard the provisions
of Paragraph 765 (which allows that Pillar 3 disclosures need not be
audited externally, unless otherwise required) as an empty gesture,
since no large issuer is going to be disclosing material public
information without appropriate (but costly and time consuming)
internal review.
• And fourth, the proposed disclosures will create an uneven
playing field between banks and their non-bank competitors, who will
be free to pursue their business activities unencumbered by
supervisory capital rules and the excessive compliance costs that they
will engender.
We recommend that Pillar 3 be eliminated or, at least, made
voluntary, so that the market and those agencies that are appropriately
tasked with safeguarding the interests of investors (i.e., the SEC, the
FASB, and the rating agencies) could determine the need for any
additional disclosure about a public company's risk profile and risk
management practices.
MACRO-LEVEL TECHNICAL CONCERNS
Let us now address some macro-level technical concerns that we have
with the proposed Accord. These issues deal with the topics of Pillar 1
Conservatism, Operational Risk, and the Accord's treatment of Goodwill,
the Loan Loss Reserve, and Expected Losses.
Excessive Conservatism -- We believe that Pillar 1 contains
excessive conservatism that would, in aggregate, significantly overstate
banks' need for capital and would propose that either Pillar 1 be
modified to be more consistent with bank risk estimation practices or
that Pillar 2 be expanded to create a forum for banks to present
evidence in support of their contradiction of the Pillar 1 formulae.
Examples of the proposed Accord's conservatism include the following:
1) No capital relief is given for credit portfolio
diversification - At Wells Fargo, we believe that we have
consciously crafted a distinct competitive advantage by virtue of the
diversity of our underlying businesses. Between mortgage banking,
commercial banking, insurance, retail deposit taking, and asset
management services (to name a few of our over 80 businesses), along
with the significant economies of scale that we have in each of these
businesses, we feel that Wells Fargo has created a portfolio of risks
(both credit and non-credit) whose worst-case loss potential is
substantially less than the sum of its parts. In fact, when we have
simply modeled portfolio losses across all of our various credit
portfolios in the past, we typically have concluded that the
worst-case overall credit portfolio result is roughly 65-75% of the
raw summation of the individual sub-portfolio worst-case events - a
significant impact. We also understand that the capture of such
capital benefits may be allowed under the AMA modeling of operational
risk. If this is, in fact, the case, then why would this logic not
extend to the modeling of capital for credit risk, where the impact is
more substantive and more empirically justifiable?
2) Limited capital relief is given for future margin income
- Internal capital generation acts as a primary buffer against losses
in the portfolio, even before loan loss reserves and equity capital
are drawn upon. While this concept has long been valued by bank debt
rating agencies in their evaluation of bank capital structures and
securitizations of pools of assets, it has been virtually ignored in
the Accord. Even recent amendments to the Accord with respect to
Future Margin Income are fundamentally understated, by virtue of
restricting their focus to higher-margin retail lending portfolios and
operational risk. Margin income is found throughout a diversified bank
holding company and, regardless of its source, serves as a component
of internal capital generation. Stated simply, it is not the risk
alone of extending credit that creates a requirement for capital
outlay at a financial institution. It is this risk absent a
compensatory reward that raises capital requirements. We would argue
that some fraction of Future Margin Income should be deducted from all
Pillar 1 capital formulations.
3) 99.9% confidence level as a minimum standard - The Accord
employs a 99.9% confidence level (roughly a single-A debt rating for a
one-year horizon) as the minimum capital requirement before potential
Pillar 2 and "well-capitalized" increments are taken into account. We
would recommend either setting the minimum standard closer to a level
associated with a low investment grade rating, or employing the 99.9%
level as the well-capitalized standard (after stress tests and FDICIA
prompt corrective action provisions have been take into account).
4) Unrealistic asset correlation assumptions - The Accord
employs unrealistically high asset correlation assumptions in the
risk-weighted asset calculations, which make the estimated 99.9"'
percentile loss level arbitrarily high in the first place. These
assumptions result in an exaggerated view of worst-case loss levels
across all of the retail lending product categories, and are
particularly misrepresentative in the case of high-EL/high-FMI
(non-prime) retail lending.
5) Stress testing requirements - The Accord requires stress
tests to the 99.9th percentile calculations, which may translate into
required capital in excess of the 99.9th percentile. We do not
understand the need for such a required incremental capital buffer, if
so high a minimum confidence level has already been assessed.
6) Omission of the tax consequences of losses - The Accord
fails to recognize the fact that worst-case losses should be supported
by capital on an after-tax, rather than pre-tax, basis, thereby
reducing the amount of capital required. After all, the actual drain
on retained earnings occasioned by most losses is inclusive of the tax
benefit associated with those losses. The omission of this benefit
effectively overstates the required capital support for a business by
30-40%!
7) Required conservatism in EAD/LGD estimation - The Accord
forces the use of conservative, rather than expected, estimates for
EAD and LGD. This directive has a multiplicative impact on worst-case
loss estimates. In addition, in the case of retail exposures secured
by residential properties, a minimum LCD of 10% has been mandated,
with no theoretical support. This LCD floor could also have public
policy implications, with respect to its impact on banks who use PMI
insurance as a tool to facilitate the granting of loans at attractive
rates to borrowers who have not accumulated a 20% down payment. In
such cases, the PMI insurance may well limit a bank's expectation of
LCD to below 10%.
8) Additional capital for "well-capitalized" standard - As
we understand it, in the U.S. the well-capitalized standard under the
FDICIA prompt corrective action provisions may impose an additional
2.00% total capital requirement on banks, on top of the conservatism
already built into the assumptions above.
Operational Risk -- With respect to the Advanced Measurement
Approach to Operational Risk, there are several issues that, we believe,
need to be resolved:
• Certain operational loss events are relatively small and
frequent. Such events can be successfully modeled through the use of
statistical techniques applied to historical data sets. Because such
losses are relatively predictable, they can effectively be priced into
the product, in much the same manner as expected credit losses are
priced into credit products, and we support the Committee's decision
to allow Future Margin Income to offset the expected component of such
losses.
However, we are doubtful that similar statistical techniques can be
applied to historical data to reliably model extreme
operational loss events. Truly catastrophic loss events cannot be
predicted, and no amount of capital will protect an institution in
such an instance. We believe that some form of qualitative (scenario
analysis) modeling is more appropriate in assessing those types of
loss events that are less predictable. Accordingly, we think that more
development is necessary to finalize exactly what types of loss events
ought, realistically, to be captured under AMA approaches to
Operational Risk capital formulations.
Wells Fargo very much supports the use of information databases and
statistical analysis, but only as a means of understanding/managing
its operating expenses, not as a requirement for establishing capital
levels.
• To the extent that extreme operational loss event modeling is
deemed realistic, we see no reason why the recognition of insurance
mitigation should be limited to 20% of the total operational risk
capital charge, as suggested by Paragraph 637 of the Consultative
Paper. To do so might lead to imprudent risk management incentives in
the use of insurance programs.
• We do not believe that the direct incorporation of external loss
data should be a required component of a bank's operational loss
modeling. While it is instructive for banks to be aware of external
loss events, applying that information across all institutions in a
formulaic manner seems problematic to us. Without a relatively
detailed awareness of the internal control conditions that led to
those losses at other institutions, it is difficult, at best, to do
much more than guess the impact of a seemingly similar event on a
given bank. Accordingly, external data should only be one of several,
optional considerations when performing scenario analysis, and not
necessarily the most important.
The proposed AMA framework for Operational Risk leaves banks with the
task of developing a complex and costly methodology for operational loss
estimation. This choice begs the question of whether there may be an
alternative approach to determining operational risk capital that is
consistent with the way sound businesses actually operate without being
overly complex or costly to administer.
For example, we note that the well-known concept of operating
leverage, or business risk, seems to be totally overlooked in the Basel
Committee's operational risk capital deliberations. We feel that
constructing a business-based approach to operational risk capital
should be viewed as an acceptable alternative to the AMA track. We would
encourage further discussions between the regulatory agencies and their
regulated institutions along the lines of quantifying the main elements,
definitions, and procedures of this type of framework.
Because there is no accepted methodology for quantifying Operational
Risk, we believe that the AMA approach should not be the only option
made available to U.S. banks. All institutions subject to the Accord
should be allowed to develop any risk measurement methodology (Basic
Indicator, Standard, AMA, or an alternative such as a business-based
approach) that is acceptable to their national banking supervisors, and
to disclose their methodology and their key controls for managing
operational risk in their public filings.
Treatment of Goodwill as Capital - Subsequent to the inception
of the existing Risk-Based Capital Accord in 1988, the accounting
principles (GAAP) that affect the treatment of the Goodwill asset on the
balance sheet have changed. Under GAAP today, Goodwill must be revalued
to its fair market value on a quarterly basis. As such, we believe that
Goodwill now represents an asset with an accepted value equal to its
recorded balance sheet amount, and should no longer be a required
deduction from Tier 1 Capital in the regulatory capital calculations. In
contrast to other banking assets that, by GAAP standards, are subjected
to similar impairment analyses on an ongoing basis, the capital
treatment of Goodwill is disproportionately harsh.
Use of Loan Loss Reserve as Capital -- We believe that banks
should be allowed to effectively count their entire loan loss reserve (ALLL)
as capital, rather than having its usage capped (at 1.25% of
risk-weighted assets (RWA), or aggregate expected losses (EL)). If usage
of the ALLL is capped, a major portion of three primary buffers against
loss volatility - portfolio diversification, margin income, and part of
the loan loss reserve - will effectively have been ignored. It would
also be the case in this instance that banks with low expected losses
would receive an arbitrary capital advantage, since it is more likely
that their ALLL would "fit" under the 1.25% of RWA cap.
Wells Fargo thinks of the loan loss reserve as another form of
capital. We see no reason why banks should not be able to effectively
count their entire ALLL as capital, regardless of the proposed treatment
of EL in the risk-weighted asset formulae. It is particularly
objectionable to us that the current proposal gives an arbitrary
advantage to some banks in terms of their ability to make full use of
their ALLL.
Treatment of Expected Losses (EL) as Capital - As a separate
issue from the use of the ALLL in the capital calculation, Wells Fargo
supports the widely-held industry belief that capital is not needed to
cover EL because bank pricing practices are generally constructed such
that pricing covers expected losses, other expenses, and a targeted
minimum return on economic capital. Stated differently, risk does not
emanate from losses that are expected and priced for; it is created by
uncertainty, in terms of unexpected credit events or mis-managed
operating leverage.
Consequently, we would suggest that EL be excluded from the
computation of required capital. If this treatment is not adopted, it
seems to us that the only fair approach is to permit consideration of
those elements that act as offsets to EL in practice - the full amount
of the loan loss reserve and an appropriate portion of Future Margin
Income (discussed earlier). We believe that excluding EL from the
capital calculation would be the simpler and, actually, more
conservative, in terms of resulting in a higher capital requirement when
compared to the alternative of subtracting Future Margin Income.
We would also repeat that, in its current form, the Accord is
internally inconsistent in its treatment of EL. It permits Future Margin
Income to offset EL in the case of qualifying revolving retail exposures
and operational risk, but does not allow it for any other banking risks.
We find this illogical.
MICRO-LEVEL TECHNICAL CONCERNS
Finally, we have some detailed technical concerns with the current
wording of the proposed Accord. These issues are clearly subordinate to
some of our overriding concerns, but if the Basel Committee is
determined to continue on its current path, then we feel that our
remaining issues should be addressed, so as to make the compliance
burden somewhat more reasonable for the affected banks.
Definition of Default -- We believe that the definition of
default outlined in paragraph 414 should be simplified to correspond
more closely to what is more commonly used by risk practitioners. That
is, loans that fall under the corporate and specialized lending models
should define default to coincide with the incidence of non-accrual
status, and loans that fall under the retail model should define default
to coincide with the Uniform Retail Credit Classification standards
published by the FFIEC. In the absence of this change, banks will be
forced to track two separate measures of default - one for internal risk
assessment and a second for regulatory capital purposes. This would seem
to be a meaningless exercise, since the ultimate driver of risk is loss,
and these fine lines of default definition will only serve to shift the
mix of PD and LGD, without significantly affecting ultimate loss.
A related issue evolves from the interplay of paragraphs 414 and 366.
Paragraph 366 prescribes that banks must have one point on their
borrower rating scales that is reserved solely for defaulted loans. We
see no reason why it should be necessary to create a risk rating bucket
that, by design, has a 100% PD, so long as a bank would always be able
to identify what the actual default rate is for each of its rating
buckets. While it is highly likely that defaulting borrowers would
congregate at the lower end of a rating scale, we do not think that a
unilateral default rating construct should be prescribed to banks. This
becomes a potentially bigger issue when added to the fact that we
disagree with the proposed definition of default in the first place. As
a result, banks are faced with another unnecessary cost of creating
parallel risk rating methodologies, with no value added to the risk
management process.
Electronic Storage of Guarantor Rating Histories - Another
unnecessary cost that we perceive in the proposed Accord is the
requirement in paragraph 392 that banks maintain rating histories on
recognized guarantors. While we agree with the standards that are laid
out in the Accord for the recognition of guarantees, we feel that a
lender's supporting documentation for 1) the recognition of a guarantee,
2) analysis of the strength of a guarantor, and 3) the PD estimate
attached to the guarantor should only need to appear in the physical
credit files. It would be unnecessarily costly, confusing, and without
any value, to reproduce this data electronically when Expert Judgment
risk rating systems are employed. In particular, instances of partial
guarantees or multiple guarantees make the systematic storage of such
data problematic. This is another aspect of the data maintenance
requirements of the Consultative Paper that we feel is overly
prescriptive and adds unnecessary costs to the implementation process.
Capitalized Future Margin Income - We feel that paragraph 523
in the securitization section of the Consultative Paper is too vague in
its statement that "Banks will be required to deduct from Tier 1 capital
any expected future margin income (FMI) (e.g. interest-only strips
receivable) that has been capitalized and carried as an asset on the
balance sheet and recognized as regulatory capital." We believe that
this paragraph was intended to only refer to credit enhancing
interest-only strips receivable. Mortgage Servicing Rights (MSR's) and
other non-credit sensitive interest-only strips are sometimes retained
and capitalized on the balance sheet. To avoid confusion, we would
suggest that paragraph 523 be augmented to clarify that MSR's and
noncredit enhancing interest-only strips (whether in securitized or
non-securitized form) are explicitly excluded from its scope.
Implicit Support -- In a similar fashion, we would suggest
that the concept of "implicit support" of securitizations mentioned in
paragraphs 513 and 524 be clarified so that it is understood that this
concept does not extend to situations where banks buy loans out of pools
for breaches of contractual representations and warranties which they
have made as sellers and servicers in securitizations. In addition, it
should be made clear that the term "implicit support" does not cover
instances in which mortgage servicers periodically buy back loans from
GNMA securitization pools under GNMA's Early Pool Buy-out Program.
Purchase of these loans does not create any incremental credit support,
as these securities are covered by the full faith and credit guarantee
of the U.S. government.
Risk Weights for Securitization Tranches -- We believe that
the proposed risk weights in the Ratings-Based Approach to be used by
Investing Banks in the mezzanine and senior tranches of securitizations
are too high, and could lead to irrational incentives to trade
securities. These weights could be made to coincide more closely with
the weights generated by the corporate risk weight formula for assets
with comparable PD's. In reference to Paragraph 575 of the Consultative
Paper, we also believe that originators should not be treated
differently than investing institutions with respect to the capital
treatment of retained or repurchased tranches of securitizations. Rather
than being required to deduct from regulatory capital all positions
below KIRB regardless of rating, originators should be allowed to apply
the same RBA risk weights used by investors for the subject tranches
when performing the calculation, since the risk is the same.
Specialized Lending Rating System Design -- Paragraph 362 of
the Consultative Paper describes an exemption from the two-dimensional
rating system design requirement that is available to banks using the
supervisory slotting criteria. It states that "given the interdependence
between borrower/transaction characteristics in Specialized Lending,
banks may satisfy the requirements under this heading through a single
rating dimension that reflects EL by incorporating both borrower
strength (PD) and loss severity (LGD) considerations." We agree about
the presence of significant correlation between PD and LGD in commercial
real estate lending, and feel that Advanced IRB banks should be allowed
the same flexibility to use a single rating scale to assess risk in
investor/developer real estate lending. We believe that this would be a
much more reliable manner in which to capture the collateral-intensive
nature of that business and its correlation with borrower PD.
SME Risk Weight Function -- The capital formulation for SME's
(small and medium-sized enterprises) should be simplified so that it is
not so complex and, potentially, costly for banks to comply with, in
terms of assembling the required data. There is little theoretical
support for modeling borrower asset correlation as so granular a
function of sales size as is suggested by the Accord. We do not
understand why a lower asset correlation specification could not be
devised, using the same functional form, but lower parameter settings,
as the Corporate risk weight function, while simply stipulating a
maximum sales size for a borrower to be considered an SME. Ideally, this
function could also be made to eliminate the arbitrage possibilities
that currently exist between corporate and retail SME risk weightings.
Overdrafts -- We believe that the treatment of overdrafts
outlined in paragraph 421 is potentially destructive and should be
clarified so as to ensure sound risk management of overdrafts. Paragraph
421 states that "Authorized overdrafts must be subject to a credit limit
set by the bank and brought to the knowledge of the client". We
interpret this passage to mean that, assuming a bank does calculate and
deploy an overdraft limit for each checking account (whether business or
consumer), the bank needs to notify the client of the available
overdraft limit. If this is the proper interpretation, a bank is put in
a difficult position in terms of notifying the client about the limit.
This would increase the risk of the deposit account, exposing the bank
to adverse selection. Clients might focus not on what funds they have in
their checking accounts (avoiding overdrafts), but, rather, on the
amount that they can legitimately overdraw their account, potentially
increasing the amount of losses resulting from overdrafts.
Interest Receivables - We believe that the balance sheet item
called "Accrued Interest & Fees Receivable" should receive a 0% risk
weight, since the credit risk associated with this account is captured
in the economic loss measured for the associated asset portfolios as
part of the LGD parameter estimation methodology. This logic may also be
applicable to "Other Real Estate & Other Collateral Owned," depending on
the time horizons used by banks in estimating LCD's for the underlying
asset portfolios. The conditions under which a 0% risk weight could be
justified for these asset classes should be made clear in the final
rules.
In conclusion, we would like to acknowledge the work done by the
Basel Committee and its support staff in raising the awareness of the
complexity of today's risk management process in a dynamic banking
environment. We are hopeful that our thoughts expressed here are helpful
not only in terms of pointing out issues with the proposed Accord, but
also in suggesting solutions.
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