It is an
honor and a pleasure to be with CSFI as it celebrates ten years of
distinguished service to the financial community. The roster of your officers,
sponsors, and trustees as well as the impressive list of CSFI publications
makes it self-evident why the organization enjoys the reputation it does. I
particularly want to express my appreciation to Sir Brian, Minos Sombanakis,
and Andrew Hilton, for the invitation to speak as well as for this evenings
fine hospitality.
When I
alluded to your distinguished service to the financial community, I was
obviously not referring to service in the same sense one might use the term
in a gathering of back-office consultants or software developers. What CSFI provides is quite different and
extraordinarily important in an age when polemics and self-interest masquerade
as solemn truth. What CSFI gives us is judgment we can trust, perspective we
can apply, and forthright analysis that is indispensable to our understanding
of the pressing policy issues of the day.
For
internationally active banks, their supervisors, and those who try to make
sense of it all, no public policy issues matter more than those currently on
the table at Basel. In the U.S., Basel
II has recently attracted a great deal of attention from banks and policy
makers following a Congressional hearing in mid-February at which I expressed
concerns with the proposal.
It has certainly been a difficult journey for the members of
the Basel Committee and the various working groups and task forces from the
central banks and supervisory agencies that are so heavily involved in the
Basel process. We have been at it for nearly four years now, and will be at it
for some time longer at least until the end of 2003.
With respect for the kind of perspective that informs so
much of CSFIs work, I thought that I would step back and look at Basel II in
the context of the history of capital regulation. In what ways does Basel II
draw on the experiences of the past and to the extent that it is leaving
experience behind and breaking new ground, what kinds of issues may it be
raising?
One neednt go back too far the late 1970s would do to
find a time when many bank supervisors believed they could easily get along
with no formal rules on capital. Experience had taught them that such simple
ratios as capital to assets and capital to total deposits were not very useful,
and that supervisory judgment was a far better tool than mathematical
ratios. I recall asking the head of
supervision at the Federal Reserve years ago how much capital was enough, and
he answered, I cant tell you, but I know it when I see it a response that
sounded eerily like that of a late U.S. Supreme Court Justice who was asked to
define obscenity.
In any case, bank supervisors of a generation ago were
reluctant to place too much faith in fixed capital ratios, partly because they
feared giving rise to a false sense of security or insecurity about the
safety and soundness of the banking system, and partly because the idea that
formulaic ratios should carry any decisive weight in an assessment of a banks
condition offended their sense of professionalism. It had taken many decades to
overcome the view of the bank examiner as an accounting clerk with enforcement
powers people who might be depended upon to find shortages in the till or
moribund loans still being treated as viable, but not much else. In place of
that image, a shiny new one was evolving of bank supervisors, whose
expertise in banking and finance was matched only by their intuition,
discretion, and ability to look beyond the raw numbers to discern the true
condition of the institutions under their responsibility.
Not surprisingly, therefore, in the United States the
initiative for a return to capital ratios as a supervisory mainstay came not
from bank supervisors themselves, but rather from lawmakers reacting to the
rather abrupt deterioration of the U.S. banking system during the late 1970s.
Post-mortems on several high-profile failures revealed that the industrys
capital-to-assets ratio had been eroding for some time, although it was never
definitively established that more capital would have averted or significantly
ameliorated the crisis. Regardless, in response to congressional pressure, the
regulatory agencies, including the OCC, adopted blunt regulatory capital
requirements.
As the regulators had predicted, problems quickly cropped
up. First, by each adopting its own requirements for regulatory capital, the
agencies inevitably found themselves in conflict with one another. That
generated restrained dispute among the regulators and the advocates for their
respective points of view. But more
importantly, it led regulated institutions to engage in a new form of
regulatory arbitrage, since it was a simple matter to move to the charter that
offered the most permissive approach to capital. In the international arena, it also created invidious
distinctions among institutions competing across borders, affording a
competitive advantage to those whose home country supervisors took a more
lenient approach to capital.
Congress took steps to deal with the domestic ramifications
of the problem in several legislative enactments. In 1978 it created the
Federal Financial Institutions Examination Council, with a mandate to achieve
greater uniformity among the supervisory agencies. In the International Lending
Supervision Act of 1983, it required the U.S. banking agencies to do what they
had already done voluntarily, if reluctantly, in regard to capital policy, and
in 1984, the Federal Reserve, the FDIC, and the OCC agreed to revise their new
capital-adequacy guidelines to establish common capital standards for all
banking organizations.
The goal of creating a more level playing field for
financial institutions and promoting more consistent supervisory treatment of
those institutions -- was one of the central objectives of the Basel Committee
from the time of its inception in 1974, and it remains one of its overriding
objectives today. By the mid-1980s, the Committee had turned its attention to
the development of common capital standards for all internationally active
banks.
But the Basel process took off in a different direction from
where the U.S. had started under congressional mandate and it produced very
different results. France, the United
Kingdom, and Germany had adopted risk-based capital standards starting in the
late 1970s, reflecting the industry shift toward higher risk assets and
off-balance sheet activities. This approach involved less prescription and more
discretion on the supervisors part than the more rigid, formulaic approach
that U.S. supervisors had objected to but adopted nonetheless under pressure.
The European approach became the starting point for work on an international
capital accord and, with minor exceptions, its end result.
The Basel Accord set forth capital standards that U.S.
supervisors were well satisfied with capital standards that not only went a
long way toward harmonizing international practice, but that also carved out an
important role for supervisory judgment and expertise in determining how much
capital a particular institution required, given its risk profile.
If the Basel principals thought that the publication of
their work marked the final word on the subject, however, they were mistaken.
First, at least in the United States, the adoption of the Basel Accord
represented no definitive ratification of the philosophy it embodied. Indeed, the
Basel approach scarcely survived the U.S. banking crisis that was already
underway when the Accord was adopted. In the light of mounting losses and near
insolvency of the federal deposit insurance fund, supervisory discretion the
underlying approach of Basel -- was increasingly viewed as a euphemism for
forbearance, which even some U.S. bank supervisors, under the spotlights,
conceded had helped to create and prolong the crisis. In the FDIC Improvement
Act of 1991, Congress acted to strip away some of that discretion. Putting
strong new emphasis on prompt corrective action that is, a mandate to
supervisors to force remedial steps, including recapitalization, when capital
levels fall Congress hard-wired a set of capital trigger points in an effort to
limit discretion and to prevent forbearance by the banking agencies not
recognizing that since the supervisors retained the power to assay what the
level of capital actually is, any effort to force action based on specific
capital levels was not likely to eliminate discretion from the process.
Its unclear which strain in the current philosophical
duality is responsible for the industrys impressive current capital strength.
However, some bankers have since spoken of their experiences during the crisis
of a decade ago as a personal turning point that convinced them never again to
split hairs over the risk weight of a given asset and to build capital well
beyond regulatory minimums to enable them to weather any foreseeable
contingency.
Looking back from todays perspective, the original Basel
Accord Basel I may be viewed as charmingly unsophisticated, comprised, as
it was, of a handful of prefabricated risk buckets. Two things became clear
before long: first, that these rather coarsely structured buckets had little
to do with real risk; and, second, that it was a simple matter to arbitrage
from one bucket to another. These realizations helped to give birth to Basel
II.
The authors of Basel II established a noble and ambitious
set of goals for themselves: to integrate all that we have learned about
capital regulation and risk over the years in a single, logically consistent
package; to accommodate, if not resolve, the chronic tension between
prescription and supervisory discretion; to recognize the technological and
conceptual advances in the science of risk management, and to provide
incentives for bankers to make use of those advances; to fine-tune our current
risk ratings in a way that makes them more sensitive, more discriminating, and
more forward-looking; to supplement the risk judgments of supervisors with
those of the marketplace and of bankers themselves; and to ensure that the
regulations we produce are relevant to the massive changes that have occurred
in international banking structural changes, portfolio changes, and
management changes since Basel I.
I assume that this audience is reasonably familiar with the
key features of Basel II, but at the risk of being tedious, let me briefly
outline the structure. The new approach would be built on three pillars the
first, a set of formulas for determining regulatory capital; the second, a set
of principles for the exercise of supervisory oversight; and the third, a set
of disclosure requirements intended to enhance market discipline.
Pillar I
basically sets out three means for calculating capital:
The standardized approach essentially, a set of
refinements to the old risk buckets, which provides for the use of external
ratings in certain circumstances, and gives some weight to risk mitigation
devices.
The foundation internal ratings-based (IRB) approach,
which sets forth a methodology for using a banks own internal risk rating
system, including its calculated probabilities of default (PD), as a base for
calculating capital, using a factor for loss given default (LGD) provided by
supervisors.
The advanced IRB approach, which bases capital
calculations on the banks own supervisory-validated models, including
bank-calculated PDs and LGDs.
In each of the three approaches there would be a separate
calculation for determining an assignment of capital to cover operational risk.
In measuring their operational risk, banks can choose between a basic approach,
a standardized approach that looks at individual business lines, and an advanced
measurement approach.
I suppose
in one respect the result of such an ambitious undertaking might have been
predictable. The process has generated a lengthy and complex product, as the
Committee has sought to develop a risk-based rule that could be applied to
banks around the world with varying degrees of sophistication. Part of the
complexity of the most recent comsultative paper (CP-2), which will be
reflected in the soon to be released CP-3, is simply the consequence of there
being so many different components of the rule, and thus a variety of possible
permutations.
When I have complained in the Basel Committee about the
complexity of the paper, I am roundly admonished by my colleagues. We live in
a complex world, they say. Dont quibble if we try to fashion capital rules
that reflect that complexity. But with great respect for my colleagues, the
complexity we have generated goes far beyond what is reasonably needed to deal
with the intricacies of sensible capital regulation. It reflects, rather, a desire to close every possible loophole,
to dictate every detail, and to exclude to the maximum extent possible any
opportunity for the exercise of judgment or discretion by those applying and
overseeing the application of the new rules. In short, it reflects much more a
commitment to prescriptiveness than a mere recognition of the complexity of
todays banking business. To be sure,
much of the complexity also reflects the myriad compromises negotiated in the
drafting process. And therein lies the
greatest obstacle to simplification, for almost any effort to simplify runs the
danger of being viewed as having the potential to upset compromises that have
been hammered out.
This complexity has a price. Most obviously, it will impose
a heavy cost burden on bankers, who have to design systems and educate staff to
deal with the complex new rules. It may also have a cost in terms of
credibility and public acceptance, for if legislators, customers, and market
participants cannot penetrate the new rules, can we expect them nonetheless to
love and respect them?
Finally, it may have a cost in terms of competitive
equality, and this is what concerns me most. Bank supervision varies
significantly from one country to another in approach, intrusiveness, and quality.
Is it realistic to think that an enormously complex set of rules will be
applied in an evenhanded way across a broad spectrum of supervisory regimes?
For example, the OCC has as many as 30 to 40 full-time resident examiners in
our largest banks. They are intimately involved as supervisors in watching the
banks operations and judging the banks compliance with a myriad of laws,
rules, and guidelines. Some other countries may send examiners in once a year
to a comparably sized institution, or may examine such an institution
thoroughly only every five or six years, or may put heavy reliance on the
oversight of outside auditors.
Its fair to ask, I think, in which regime hundreds of pages
of detailed, prescriptive capital rules are more likely to be robustly
enforced. The Basel Committee has not undertaken to set standards of
supervision for member countries. Yet the attainment of competitive equity
among internationally active banks is a bedstone principle of Basel II. Can we
really achieve competitive equality without addressing disparities in
supervision particularly when we are operating on the assumption that the
complex new rules were writing will be applied in an evenhanded way throughout
the world?
As a practical matter, particularly given the rigorous
schedule set by the Committee, I think it is unrealistic to think that we will
see significant simplification in the next iteration of the proposal. I would count it a major achievement,
nonetheless if we were able to do no more than simplify the articulation
of the proposal.
I cannot resist recalling words that seem peculiarly
relevant to this effort. In the 1780s, as Americans engaged in a great debate
on the principles that should underlie their new government, one of the most
original of our thinkers on that subject (and later president), James Madison,
contributed an important insight. Popularly elected governments do not
automatically command popular confidence, Madison observed. It will be of
little avail to the people if laws are made by men of their choice, if the laws
be so voluminous that they cannot be read, or so incoherent that they cannot be
understood. Certainly what has come
out of Basel has been voluminous; whether it is incoherent I shall leave for
you to decide as you try to make your way through it.
So where do we go
from here? The Committee has reaffirmed
its intention to release a third consultative paper for comment in early May,
with a view toward issuing a final document by year-end. While some have argued that we should scrap
the whole Basel II process and go back to the drawing board, or even adopt an
entirely new approach, that is not going to happen. There is enormous momentum being generated by Basel Committee
members, and by the central bank governors who comprise the Bank for
International Settlements, to move ahead with the current approach on the
current timetable.
In the U.S., the three bank regulatory agencies (Fed, FDIC,
and OCC) have jointly agreed to three steps to simplify our implementation of
Basel II.
First, we will make available to U.S. banks only the
advanced IRB and the advanced measurement approach to operational risk. The
U.S. agencies will likely propose for notice and comment a Basel II-based
regime incorporating the Advanced IRB approach for credit risk, the AMA for
operational risk, and the internal ratings approach for market risk. The
underlying strategy is that banks would realize lower capital charges as they
moved up the scale of sophistication, and would thus have an incentive to make
the investment in systems required to make such a movement.
Second, we will apply Basel II only to our large
internationally active banks. We do not
intend to apply it to the thousands of smaller community banks we have in the
U.S. While other banks in the U.S. can apply to come under Basel II, we
anticipate that at the outset only a very few will do so although we also
anticipate that market forces will drive some of them in this direction. We expect these two actions will make it
easier for us to develop a draft U.S. regulation, which will in effect be a
subset of Basel II, and by limiting the number of banks coming under Basel, it
will help focus these key banks on the proposal during the comment period,
which we expect to undertake this summer.
Third, in drafting the proposed U.S. capital framework, we
will use a combination of regulatory language and supervisory guidance to
translate the objectives and principles of Basel II into terminology and a
framework consistent with the U.S. approach to capital regulation. We expect
the U.S. rule will require at least as much capital as a literal interpretation
of Basel II; at the same time, we will seek to write regulations and guidance
that can be understood by both our large banks and by the line bank supervisors
enforcing the new capital rule -- mindful that we are required to articulate
all our regulations in plain English.
In the U.S., our
Congress is just beginning to focus on this subject, and is considering what its
role should be in the process. While to
date the heavy lobbying has been related to the handling of operational risk,
there is still a possibility, in my view, that Congress could be energized by
some of the large internationally active banks, if they are discontented with
the terms of Basel II in its final iteration, or with its impact on their
required capital, or by smaller banks claiming that they will suffer a
competitive inequity because they dont have access to the potential capital
reductions offered the large banks. Members have been particularly insistent
that when U.S. regulators translate Basel II into specific regulatory language,
which will then be published for public comment, that process must have real
integrity that is, the banking agencies must give serious consideration to
the comments they receive, and, if they find some problems, must resolve those
issues or bring them back to Basel for further consideration. Let me reaffirm
that the OCC and the other U.S. banking agencies cannot sign off on a
final Basel II framework until we have weighed the final product in the light
of all the comments we receive and have
determined that we can implement the new rules in a way that does not
compromise safety and soundness or the competitive strength of our banking
system. We expect that other countries will go through a similar process with
their banks and may also identify substantive issues.
One safety valve
in the process is the Accord Implementation Group the Committee has
formed. The AIG will be a continuing
subset of the Committee that will address problems encountered during the
implementation phase, with the potential for mitigating unforeseen
difficulties.
The Office of the
Comptroller of the Currency has from the outset argued strongly and
consistently that Basel II must work in practice as well as in theory; that it
must provide supervisors with sufficient flexibility to accommodate differences
among financial institutions; and that it must work in a way that avoids
placing banks at a competitive disadvantage compared to other financial
services providers. In advocating these broad policy goals, the OCC has staked
out its own independent positions, as on operational risk. And while we have
not always prevailed, I believe that our efforts make it more likely that well
eventually get a workable new Basel agreement an agreement that all concerned
parties can live with and prosper under.
One final word on
timing. The Basel Committee, under the strong and intelligent leadership of
Bill McDonough, has wisely set time frames as a means of disciplining itself,
and we will work earnestly within the Committee in an effort to achieve that
schedule. We need to be sure, however, that we get it right. We have taken on a
huge task for ourselves as supervisors, and we are confronting our banks with
imposing new challenges and cost burdens. The new rules will govern banking for
many years to come, and we need to keep the long view in mind, even as we press
ahead.
In that endeavor, we
have counted on the support and assistance of CSFI, and look forward to
continued collaboration with you on Basel II and beyond.
# # #
|
The OCC charters, regulates and examines approximately
2,100 national banks and 52 federal branches of foreign banks in the U.S.,
accounting for more than 55 percent of the nations banking assets. Its
mission is to ensure a safe and sound and competitive national banking system
that supports the citizens, communities and economy of the United States.
|