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Thursday, February 27, 2003
U.S. House of Representatives,
Subcommittee on Domestic and International
Monetary Policy, Trade and Technology
Committee on Financial Services,
Washington, D.C.

    The subcommittee met, pursuant to call, at 10:05 a.m., in Room 2128, Rayburn House Office Building, Hon. Judy Biggert [chairwoman of the subcommittee] presiding.

    Present: Representatives Biggert, Kennedy, Feeney, Oxley, Hensarling, Murphy, Barrett, Harris, Maloney, Lee, Sherman, Frank, Baca, Emanuel, Capuano and Lynch.

    Chairwoman BIGGERT. [Presiding.] This hearing of the Subcommittee on Domestic and International Monetary Policy, Trade and Technology will come to order. Without objection, all members' opening statements will be made a part of the record. We would like to welcome everybody here today. I will start with my opening statement.
    Good morning. I would like to thank the witnesses for appearing this morning to outline the revisions of Basel Capital Accord, currently under discussion at the Bank of International Settlements. We have two very knowledgeable panels of experts before the subcommittee today, and I look forward to your testimony.
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    The Basel Accord plays such a critical role in the operations of every bank that any changes to this accord must be closely monitored by the regulators and the Congress. The Federal Reserve and the other regulators have been hard at work seeking improvements in the Basel I structure. I want to thank you for all of your hard work on this complex issue. There is no question that there are flaws in the current system and change is needed. Many of the proposed changes to the Basel Accord are sound and will go a long way to reducing risk in the banking system and ensuring the efficiency of our national banks.
    I am, however, very concerned about the complexity of Basel II and the ability to effectively implement it. If we are going to go down the path of changing the primary tool used to protect against excessive risk, then we must make sure that it can be easily implemented and will not result in unforeseen costs. According to the regulators, Basel II will only apply to the largest U.S. financial institutions. However, many of us are concerned that the market could, in effect, force all U.S. institutions to comply with Basel II if they wish to remain competitive. The bottom line is that institutions that do not have the resources to turn the sophisticated models required by Basel II could be forced to consolidate their operations or to severely limit the types of products they offer.
    One of my primary concerns is the operational risk capital charge that will come under Pillar I of Basel II. This is a new capital charge which will be included with charges for credit risk and interest rate risk. Operational risk includes in its calculus possible losses from employee misconduct, fraud, system failure and litigation risk. These factors are very difficult to quantify for large banks, and nearly impossible to measure for smaller and medium-sized banks. So I question the logic of imposing a burdensome capital charge on institutions that is based mostly in theory, rather than on hard facts.
    Some have asserted that operational risk is simply the catch-all category of Basel II and has been included simply to define risks that are already accounted for in the capital accounts of most institutions. I would like to see if it would make more sense to include these risks under a more flexible Pillar II supervisory structure, instead of lumping them into a mandatory capital charge.
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    I am also interested in the issue of home host regulators and how Basel II will ensure that foreign regulators will hold their financial institutions to the high standards that U.S. institutions are held. As we saw with the Basel I proposal, too many countries agreed to submit to the capital requirement in theory, but not in practice. I want to be sure that U.S. financial institutions of all sizes are not adversely impacted as a result of Basel II.
    There is no argument that Basel I should be updated to better reflect the marketplace in which financial institutions operate today. I want to thank again and applaud the authors of Basel II for their hard work. I am concerned, however, that this process is moving forward at the speed of light and without assurances that there will not be any unintended consequences for U.S. institutions and the U.S. economy as a whole.
    I very much look forward to hearing all your testimony, and would again like to thank you for appearing before this subcommittee. I might add that I am Congresswoman Judy Biggert from the state of Illinois and vice chair of this committee, and am sitting in for Peter King, the chairman, who had a conflict today. So in case you have a strange face sitting in this seat, that is why. So I appreciate that.
    Now, I turn to the ranking member, Mrs. Maloney of New York, for her opening statement.
    Mrs. MALONEY OF NEW YORK. I thank the acting chairwoman, and share many of the sentiments that she expressed in her opening remarks. I am very pleased to welcome Comptroller Hawke back to the committee, as well as Chairman Powell and Vice Chairman Ferguson. It is good to see all of you again, and I look forward to your testimony.
    This morning's hearing focuses on a critically important issue for our economy, and the safety and soundness of our financial system-the new Basel Capital Accord, Basel II. The first Basel Capital Accord established the minimum standard for the banks that operate internationally. Basel II is an attempt to build on this progress by allowing financial institutions to hold capital in amounts more reflective of risk and changing market conditions. Once implemented, the final Basel II Capital Accord will have profound consequences for the banking industry, our constituents, and the economy as a whole.
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    Capital standards that are too high cut off credit, especially for borrowers with higher risk profiles. Capital standards that do not adequately protect against loss, risk the safety and soundness of the financial system. At this point in the evolution of Basel II, I believe that there is much to praise in the work of the committee, but serious areas of concern remain.
    The effort to align capital more closely with actual risk is a significant improvement over the current one-size-fits-all regime. At the same time, I share the concern expressed by some regulators and banks about the complexity and competitiveness issue raised by placing operational risk under Pillar I of the new Basel Accord. Operational risk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems, or external events. These are extremely varied scenarios. They include potential natural disasters, terrorist attacks, actions of rogue traders and even litigation risk.
    It is my opinion that any final accord not require U.S. institutions to hold a higher amount of capital for operational risk than foreign competitors. Our supervisors are the world's most advanced and our institutions already have a contingency plan and practice risk mitigation for disasters. Even after September 11, when this attack in the heart of the world's financial center, the financial system recovered relatively well, given the scope of the disaster. I do not want to see investments and businesses' continuity planning, backup systems and insurance be reduced because institutions have to devote resources to capital changes and charges for operational risk.
    I am also troubled by the potential that U.S. institutions could have to hold additional capital because of litigation risk. In a sense, the U.S. would face the potential competitive disadvantage because our laws protect individuals against loan discrimination and allow them private rights of action.
    In addition to operational risk, there are several other issues that I hope will be addressed today. Basel II has yet to decide how host home country application of the accord will be implemented. If this is resolved incorrectly, there is the potential for competitive disadvantage for U.S. institutions if foreign banks are allowed to operate in the U.S. market under capital standards established by their domestic regulators. Additionally, some commentators are concerned that the accord could result in much lower capital requirements for large institutions, adding incentive for more consolidation in the industry. Finally, I look forward to a discussion of whether the final Basel Accord will increase the severity of business cycles by requiring additional capital during economic downturns and thereby contributing to credit crunches.
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    I thank the regulators for the thousands of hours they and their staffs have contributed to this effort, and I look very much forward to the testimony.
    Thank you.
    Chairwoman BIGGERT. Thank you.
    We are very pleased to have the chairman of the committee here today, Mr. Oxley. Mr. Oxley is recognized for an opening statement.
    Mr. OXLEY. Thank you, Chairlady. Let us first of all welcome our distinguished panel. It is good to have all of you back to the committee, Mr. Ferguson from the Fed, Mr. Hawke from the OCC, and of course FDIC Chairman Powell. Welcome back. We look forward to a spirited hearing this morning on the revisions of the Basel Capital Accord currently under discussion at the Bank of International Settlements. We have two very distinguished panels, and I look forward to both the panels' testimony.
    I want to first commend the Federal Reserve, the OCC, the FDIC and the New York Fed Chairman McDonough in particular for spearheading the reforms of the Basel Accord. The authors of Basel II have been working diligently for nearly five years to develop a workable regulatory capital regime. The primary goal of Basel II is to provide flexibility and risk sensitivity in the capital adequacy framework. This goal is laudable and will be a vast improvement over the one-size-fits-all approach of the Basel I Accord, and will certainly reduce risk arbitrage under the current system.
    This is a topic of critical importance to the banking sector and the economy. If we must sacrifice speed to achieve a workable and appropriate solution the first time, I see no problem in doing so. Basel II will impact not only the largest U.S. financial institutions, but financial institutions of every size and structure. The way banks calculate risk and compete with one another will be dramatically changed under Basel II. Specifically, I am concerned that as it is currently written, Basel II will force a medium-sized institution to either consolidate to compete with the largest banks, or simply cease to offer business lines that the largest banks can offer. According to the Federal Reserve, Basel II will only be mandatory for the 10 largest banks in the U.S., and will be voluntary for the next 10 largest banks. My concern is, what happens to the next 10 institutions and the 10 after those.
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    I believe that the proposed operational risk charge could also result in unintended consequences, forcing banks to quantify the risk of such intangibles as litigation risk, employee fraud and system failure. Operational risk assessment seems to be much more art than science, and could force institutions to take large capital charges when there is little need for them. Such charges may disadvantage domestic financial institutions by requiring capital charges for factors that are difficult to quantify and are significantly less likely to occur in other countries.
    Basel II is extremely sophisticated. The cost and complexity of the proposed Basel II Accord could prove to be overly burdensome for both the institutions and the regulators charged with enforcing the new provisions. This proposal will completely change the way that banks are overseen. As such, the regulators are going to have to retrain and hire new staff and develop new methods for bank supervision. We need to ensure that all parties affected by these changes are prepared to ensure the smooth implementation of Basel II.
    In conclusion, I want to reiterate my support for the reform of Basel I. There is no question that change is needed. However, I strongly urge the Federal Reserve and the other regulators to give serious consideration to all the comments they hear today and the comments that will be made to the third consultative paper before moving forward with any rulemaking. I am troubled that a fast-track timeline for the completion of the Basel II accord has already been established. I understand that the authors of Basel II are seeking final rulemaking to be completed by the end of this calendar year. For a regulatory structure so complex and so far-reaching, we must take a measured approach in order to ensure that all voices have been heard, and that we mitigate or eliminate any unintended consequences of Basel II to the banking sector and the U.S. economy.
    I yield back.

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    [The prepared statement of Hon. Michael G. Oxley can be found on page 54 in the appendix.]

    Chairwoman BIGGERT. Thank you, Mr. Chairman.
    We are also pleased to have the ranking member of the committee here today. Mr. Frank from Massachusetts is recognized for an opening statement.
    Mr. FRANK. Thank you, Madam Chair. I want to express my appreciation to my fellow bookend, the chairman of the committee, for responding as he did when I and others brought this to his attention, and arranging to have this hearing. I think this is very important, and the chairman, I appreciate his responding in this way.
    I am going to take the opportunity of having Basel under consideration, particularly with the Fed here, just to say on an unrelated Basel topic, I was pleased to see the recent change with regard to the risk factor and the time of loans. We had a problem because I think there is a pretty good consensus that internationally short-term capital has been a destabilizing effect in some economies. To the extent that capital went in and out in East Asia, for instance, that was problematic.
    It was called to my attention that to some extent inadvertently Basel might have been contributing to that because in the risk factor, short-term capital was considered much less risky than long-term capital. That was a clear case of a perverse incentive. I understand that there has now been a modification so that short-term capital is considered, that it is given some kind of benefit from this, that it is only three months or less and that it is focused to a great extent on trade-related. I hope we can sharpen that, because obviously it would not make sense for us to be exaggerating an area of instability. So I appreciate that. This is an example of how we need always to fine-tune these things.
    As to this particular subject, I am concerned by several points that were raised to me by some of those who would be the subject of the regulation, and that is obviously often where we get our information. I am particularly concerned about the potential negative competitive effects, both within the United States and internationally. The function that is being regulated here is one that is performed both by banks and by institutions that are not banks. What has been raised to me is the differential impact on the banks, obviously, who would now be subject if it is a Pillar I approach to a capital charge, versus competitors who would not be. That is not just a matter of fairness, because we are not here to help one institution versus another. It becomes a matter of incentives. It becomes an incentive, to some extent, for institutions interested in this not to be banks, or to be setting up institutions that are not banks, so that we would wind up having set out to increase the regulation, potentially have more of this being done in entirely non-regulated areas. That is troubling.
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    I am troubled by the potential adverse effect that has been raised by some and will be aired on American versus other institutions, depending on how this carried out internationally. I also am interested, and I particularly appreciate all three of the regulators coming here. I guess we have three out of the four. We do not have the thrift people, but on this one, I suppose they are not involved. I am interested in the legitimate differences of opinion among the regulators. Let me say I hope no one will think that it is somehow improper for various of the regulators to share with the Congress of the United States differences they may have. Once a regulation is promulgated by the appropriate processes, I would expect everybody to be diligent in carrying it out. But trying to paper over what might be legitimate differences in opinion, particularly when we are talking about some fairly technical matters, does not serve anybody well.
    So I encourage all to speak out. We know there have been some differences. We would expect that. There are institutional differences. These are not easy questions to answer, and I am appreciative.
    I want to join the chairman, too, in cautioning against excessive haste. I must say that when this was first brought to my attention, I spoke to people. I had a very good briefing, and I am very appreciative, that President Monahan of the Boston Federal Reserve arranged for me. One of the first things people told me was that this was nothing to be hasty about. I was told that this was not anything imminent. To some extent, I must say I am a little concerned when I was told that at the beginning, and now I am told, well, you have got to hurry up. I do not see any reason to hurry, and I hope that we will not be told that we are now confronting any fait accompli, that we are in plenty of time to do this.
    There does appear to be, let me say in closing, a consensus that we should have some regulation. Whether or not it should be with a formalized capital charge versus increased supervision is very relevant. Certainly while there are always risks in various things, this does seem to me to be qualitatively different from the risks that are involved when you were talking about quantifiable loans. I think the capital charge, a dollar reserve, a money reserve clearly has relevance there. Where we are talking about this area, I must say if I were coming at this myself ab initio would be more inclined to the non-charge regulatory approach, but obviously we will listen.
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    So I thank the chairman for calling the hearing and I thank the three regulators for coming forward this way. I look forward to what they have to say.
    Chairwoman BIGGERT. Thank you.
    Members will be recognized for three minutes, if they wish to make an opening statement. Mr. Hensarling of Texas? Mr. Murphy of Pennsylvania? Mr. Barrett of South Carolina? Mr. Kennedy of Minnesota?
    Mr. KENNEDY. Thank you.
    I would just echo the concerns that this does not create the international competitiveness that puts American financial institutions at a disadvantage. I am very interested in hearing your testimony. Thank you for coming.
    Chairwoman BIGGERT. Thank you.
    Mr. Emanuel of Illinois?
    Mr. EMANUEL. Thank you. I obviously look forward to their testimony and obviously the Q&A afterwards. Thank you.

    [The prepared statement of Hon. Rahm Emanuel can be found on page 56 in the appendix.]

    Chairwoman BIGGERT. Okay. Ms. Lee of California?
    Ms. LEE. Thank you, Madam Chair.
    I just thank you for the hearing and look forward to the testimony. Specifically, I would like to listen closely to how Basel II really will affect smaller banks, as it relates to the new capital requirement systems. I look forward to also returning to my district to talk to our banks and representatives in the Bay Area about it. Thank you.
    Chairwoman BIGGERT. Thank you. Mr. Baca of California?
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    To our other members that are here, Mr. Lynch, do you have an opening statement? Do you have a motion for unanimous consent to make an opening statement?
    Mr. LYNCH. I do. I would ask unanimous consent that I be allowed to make a statement, Madam Chair.
    Chairwoman BIGGERT. Without objection.
    Mr. LYNCH. Thank you very much.
    I do want to thank all of the witnesses here this morning who have come forward to help the committee with their work. I in particular want to thank David Spina and Maureen Bateman from State Street Corporation for coming here today. I am interested in hearing all of the testimony, but especially the testimony of those institutions that will have to eventually live under anything that is eventually adopted. I think that Mr. Spina will be uniquely situated to address that perspective.
    I expect that at some point, Madam Chair, we are going to be pulled out. There is a members only briefing with Tom Ridge on homeland security at 11 o'clock. I hope that at some point during the testimony here this morning and this afternoon, that we will hear from all of those, and especially Mr. Spina, on the specific issue of how will this regulation, especially Pillar I of Basel II, how will that affect institutions that have to work under that regulation going forward; how will that affect, as others have mentioned, the competitiveness of some of our institutions in this country. I want to echo the remarks and the concerns, or amplify the concerns of Mr. Frank about what this really would do in an international competitive situation with some of the banks from the European Union.
    I think there is much to be worked through in this. I hope, again, as Mr. Frank said, that this is not a fait accompli and that we really have an opportunity to look very hard at what we are about to do here, and that we protect the institutions that have protected our investors and our citizens so well in the past.
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    Thank you, Madam Chair. I yield back my time.
    Chairwoman BIGGERT. Thank you.
    Mr. Capuano, would you have an opening statement?
    Mr. CAPUANO. Yes, Madam Chairman. Again, I would ask unanimous consent that I be able to make a statement.
    Chairwoman BIGGERT. Without objection.
    Mr. CAPUANO. Thank you, Madam Chair.
    Again, I will be very brief. First of all, I thank you all for coming here. I actually thank you very much for a lot of the information we have gotten. This is a relatively complicated area. Actually, it is a very complicated area, and we need all the information we can get. I thank you all for providing that.
    For me, when I see these types of things, I see new regulation. I have never been terribly opposed to regulation per se. It is not a swear-word for me, but the question is obviously reasonable, amounts of regulation is one thing. But more important than anything else, which is my big concern with the drafts that are here, is the concept of a level playing field. I know it is nobody's intention to not create a level playing field, but particularly with the new world that we have in financial services, level playing fields are not necessarily always made based upon the organizational structure of a particular entity engaged in a business line.
    Right now, I do not know what a bank is anymore. I know people have charters, but who is a bank? Realtors are banks sometimes. banks are sometimes realtors. Who is an insurance company? Who is not? No one knows anymore. So for me, I would simply encourage, and again, I am sure you have already considered it, but as you continue, to strongly encourage that you take the old concepts of organizational structure, knowing that they are in flux, knowing that they are changing daily, and to try to create that level playing field based on a business line, as opposed to an organizational structure both domestically and internationally. I know you are trying to do that, but to me that is the most important aspect here, and I look forward to helping you; or actually hopefully not having to help you to create that level playing field.
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    Thank you.
    Chairwoman BIGGERT. Thank you.
    Let me just say before introduction of the witnesses that there is a briefing at 11 a.m., but I intend to continue on with the hearing. So I know that some of our members will be leaving, but hopefully they will return following that briefing, but we will continue with the hearing.
    Let me now introduce the members of the first panel. Dr. Roger W. Ferguson, Jr., was appointed to the Federal Reserve Board in 1997 and has been vice chairman of the Board of Governors since 1999. Dr. Ferguson was recently appointed chairman of the Committee on Global Financial Systems at the Bank of International Settlements in Basel, Switzerland. Before becoming a member of the board, Dr. Ferguson was a partner at McKinsey and Company, an international consulting firm. He received a B.A. in economics, a J.D. in law, and a Ph.D. in economics, all from Harvard University.
    Next on our panel is John D. Hawke, Jr., who has served as Comptroller of the Currency since 1998. Prior to his appointment as Comptroller, Mr. Hawke served for three and a half years as Undersecretary of Treasury for Domestic Finance, where he oversaw the development of policy and legislation in areas of financial institutions, debt management in capital markets, and served as chairman of the advance counterfeit deterrence steering committee and is a member of the Securities Investor Protection Corporation. Mr. Hawke has a B.A. in English from Yale University and a law degree from Columbia University.
    Donald E. Powell is the 18th chairman of the Federal Deposit Insurance Corporation. Prior to being named Cairman of the FDIC, Mr. Powell was president and CEO of the First National Bank of Amarillo. He received his bachelor of science degree in economics from West Texas State University, and is a graduate of the Southwestern Graduate School of Banking at Southern Methodist University.
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    Thank you all, gentlemen. Without objection, your written statements will be made a part of the record. You will each be recognized for a five-minute summary of your testimony. After all of you have testified, then we will recognize members for five minutes each to ask questions of you. If that is agreeable with you, we will begin with Dr. Ferguson for your testimony.


    Mr. FERGUSON. Thank you very much, Acting Chairwoman Biggert. Representative Maloney, members of the subcommittee, and also Representative Oxley and Representative Frank.
    It is a pleasure to appear before you on behalf of the Board of Governors of the Federal Reserve System to discuss the evolving new capital accord, Basel II. I would also at this point like to thank my colleagues here at the table for their active participation over the last four or five years in developing Basel II, and to recognize the great work not only of the Federal Reserve Staff, but also the staffs of the FDIC and the OCC who have been active participants as well.
    Basel II is a complex proposal with many associated issues, but the format this morning requires that I be brief. As you have already indicated, the board has prepared a longer statement. I am pleased that this will be part of the record. This morning, I will limit myself to only a few highlights from that statement.
    There are several points that I believe should be emphasized at the outset before I address some of the questions you have raised. First, in the United States, as Representative Oxley has pointed out, Basel II will only be mandatory for a small number of large, complex banking organizations; about ten. Other entities may adopt it if they wish, although we do not think it will be cost effective for any but the larger organizations. All adopters, both mandatory and voluntary, will be required to construct the necessary infrastructure to produce and validate the key risk measurement inputs to the Basel II framework.
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    Secondly, only those U.S. banks that adopt Basel II will be required to hold capital for operational risk. Third, beyond the required core group of ten or so, and what we expect at least initially may be another ten or so adopters by choice, all the other thousands of banks in this country will remain under the current capital structure known as Basel I.
    Finally, the process of developing the Basel II proposal has not been hasty. It has involved a truly unprecedented dialogue with banks on a wide range of risk management and capital issues. That dialogue continues, and in fact will never be over. The Basel Committee will soon be issuing a revised set of proposals that we intend to use as the basis for a U.S. domestic comment process during the spring and the summer. The Basel Committee intends to approve a revised proposal late this year, while we believe that the associated U.S. rulemaking procedures, which will be the usual ANPR and NPR procedures, will be completed some time next year. Again, I do not necessarily believe that to be a hasty timetable.
    Implementation could start as early as late 2006, but no U.S. bank will be permitted to adopt Basel II until its infrastructure for estimating the required inputs has been approved by its supervisor. It is important to emphasize that modifications to the Basel II proposals will be possible both before and after these critical milestone dates. As supervisors, we will be seeking continually to improve our understanding of the impact of the new rules and will be prepared to make necessary changes as appropriate.
    With these preliminary observations, let me quickly sketch out why we believe Basel II is necessary for the large, complex, internationally active U.S. banks. First, while Basel I is still quite effective for most banks, it is too simplistic effectively to capture the increasingly varied and complex operations of our largest banking organizations. Indeed, the Basel I capital ratios are too often misleading. Congress, you will recall, has required that these ratios be used as a mechanism for filtering the activities of banking organizations and guiding supervisory assessments of financial condition, including the need for supervisory intervention. Unfortunately, current trends will continue to erode the usefulness of the existing capital ratios for the largest banks unless significant steps are taken to address this concern.
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    Second, risk measurement and risk management practices have improved dramatically since Basel I was created. Basel II is designed to capture those changes and to induce banks to carry them forward in their own internal risk management. Third, the necessity to induce banks to apply stronger and more comprehensive risk management techniques has been highlighted and heightened by the increased banking concentration both here and abroad. In this country, we now have a small number of very large banks and bank holding companies whose operations are tremendously complex and sophisticated. Weakness, let alone failure, at any one of them has the potential for severe adverse macroeconomic consequences. The regulatory entity for these entities must therefore encourage them to adopt the best possible risk measurement and risk management techniques.
    If we do not move in this direction, the risk of a problem at one or more of these entities will rise, providing us with only two unattractive options; on the one hand, increased risk of financial instability, or the adoption of much more intrusive supervision and regulation.
    Time does not permit me to describe the mechanics of the Basel II proposal, its risk inputs, regulatory formulas, use of internal estimates, et cetera. These are all in my longer statement, which again I urge you to read for your background. I would like instead to spend my remaining time addressing a small number of issues that some banks have raised with you and with us.
    A key feature of the Basel II framework is an explicit capital requirement for operational risk; the risk that losses can incur not from extending credit, but rather because processes, systems or people fail, or some events occur. This aspect of Basel II has generated aggressive criticism from those who feel that it would affect them adversely. But clearly, operational risk is real, and indeed often produces noteworthy losses; rogue traders, fraud and forgery, settlement failures, inappropriate sales practices, poor accounting and lapses of control, slippages in custodian and asset management, and large legal settlements for alleged losses caused by bank action or inaction.
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    Indeed, I think my fellow supervisors would agree that our staffs have spent no little time dealing with operational risk issues in the last several years. Basel I bundled op risk with credit risk, which is to say it effectively ignored it. An early decision was made in the development of Basel II to unbundle other risks from credit risk, and to treat each explicitly. Most of the other risks are sufficiently modest so that they can be addressed by supervisory oversight, but the Basel Committee decided that operational risk is so important that it should be treated similarly to credit risk, with an explicit capital charge.
    The current Basel II proposals reflect this treatment, and thus the large U.S. banks required or opting to use the internal ratings-based Basel II capital requirement will also be required to hold capital.
    Chairwoman BIGGERT. Dr. Ferguson, if you could sum up. I think we will get to a lot of this in the questions also.
    Mr. FERGUSON. Okay. I have a number of other points to make, but I am looking forward to responding to your questions in that regard.
    Let me also, if I could, speak to one other issue, and then conclude by saying that there is clearly strong agreement among the regulators that it is important to move past Basel I. I was pleased to hear the subcommittee in the opening comments address that. There are a number of technical issues which I am eager to address today, but at this stage I will sum up and allow others to speak.
    Thank you.

    [The prepared statement of Roger W. Ferguson, Jr. can be found on page 74 in the appendix.]

    Chairwoman BIGGERT. Thank you very much, Dr. Ferguson.
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    Mr. Hawke?


    Mr. HAWKE. Thank you, Madam Chairwoman, Congresswoman Maloney, Chairman Oxley, Ranking Member Frank, and members of the Subcommittee. I am pleased to have this opportunity to present the views of the OCC on the Basel Committee's proposed revisions to the 1988 Capital Accord. I think it is essential that Congress have the opportunity to express its views on any regulatory changes that could affect the operations and competitiveness of our banking system, and the Subcommittee is to be commended for its initiative in this regard.
    For the past few years, the Basel Committee, of which the OCC is a permanent member, has been working to develop a more risk-sensitive capital adequacy framework. The Committee has established a target date of December 2003 for the adoption of a revised Accord Basel II. Accordingly, the OCC and the other U.S. banking agencies have already begun the process of considering revisions to the current U.S. capital regulations through our domestic rulemaking process. This means publishing proposed revisions for public comment and carefully considering the comments that we receive.
    I want to assure the Subcommittee that the OCC, which has the sole statutory responsibility for promulgating capital regulations for national banks, will not sign off on a final Basel II framework until we determine through this notice and comment process that any changes to our domestic capital regulations are reasonable, practical and effective.
    Despite the enormous effort and great progress made by the Basel Committee, serious questions remain about some aspects of the Basel II framework. The first issue is complexity. One of the goals of Basel II is to encourage financial institutions to improve their own ability to assess and manage risk, and for supervisors to make use of bank self-assessments in setting regulatory capital. But before we can do that, banks have to demonstrate that their systems, and the capital determinations that flow from them, are reliable.
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    Thus, Basel II sets detailed and exacting standards for rating systems, control mechanisms, audit processes, data systems and other internal bank procedures. This has led to a proposal of immense complexity—greater complexity, in my view, than is reasonably needed to implement sensible capital regulation. I believe we have to avoid the tendency to develop encyclopedic standards for banks, which minimize the role of judgment or discretion by banks applying the new rules or supervisors overseeing them.
    Moreover, Basel II has to be written in a manner that is understandable to the institutions that are expected to implement it, as well as to third parties. We have already seen problems in understanding the instructions for the qualitative impact study that has just been finished. It is imperative that the industry and other interested parties understand the proposed regulatory requirements.
    The second issue is competitive equality. We need to think carefully about the effects of Basel II on the competitive balance between domestic banks and foreign banks, between banks and non-banks, and between large internationally active banks in the United States and the thousands of other smaller domestic banks.
    In the United States, we have a sophisticated, hands-on system of bank supervision. The OCC has full-time teams of resident examiners on-site at our largest banks—as many as 30 or 40 examiners at the very largest. In other countries, by contrast, supervisors may rely less on bank examiners and more on outside auditors to perform certain oversight functions. Given such disparities in the methods of supervision, it seems to us inevitable that an enormously complex set of rules will be applied much more robustly under our system than in many others. Thus, the complexity of the rules alone will tend to work toward competitive inequality.
    There is also a concern about the potential effect of Basel II on the competitive balance between large banks and small banks. As it is likely to be implemented in the U.S., Basel II would result in a bifurcated regulatory capital regime, with the largest banks subject to Basel II-based requirements and all others subject to the current capital regime.
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    We expect that banks subject to Basel II will experience lower capital requirements in some lines of business than banks that remain under the 1988 Accord. That may put smaller ''non-Basel'' banks at a competitive disadvantage when competing against the large banks in these same product lines. We should avoid adoption of a capital regime that might have the unintended consequence of disrupting our current banking structure of small, regional and large banks, and take steps to mitigate the adverse effects on the competitive balance between our largest and other banks.
    Finally, for many banks, the principal source of competition is not other insured depositories, but non-banks. This situation is especially common in businesses such as asset management and payments processing. While differences in regulatory requirements for banks and non-banks exist today, many institutions have voiced concern that implementation of Basel II may exacerbate those differences to the disadvantage of depository institutions.
    The third issue is operational risk, perhaps the most contentious aspect of the proposed revisions to the Basel Accord. The OCC supports the view that there should be an appropriate charge for operational risk. But I have also consistently argued before the Basel Committee that the determination of an appropriate charge for operational risk should be the responsibility of bank supervisors under Pillar II, rather than be calculated using a formulaic approach under Pillar I. I regret to say that I have not been able to persuade the Committee to adopt this approach.
    Basel's operational risk proposal has changed considerably since it was first introduced. The current proposal, especially the option of the Advanced Measurement Approach (AMA), which the OCC helped develop, is a significant improvement over earlier proposals. The AMA is a flexible approach that allows an individual institution to develop a risk management process best suited for its business, control environment and risk culture. Nevertheless, the OCC believes that more work needs to be done to develop guidelines for the appropriate treatment of operational risk.
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    Finally, calibration. It has been a specific goal of the Basel Committee that the revised Accord be capital neutral. In other words, the aim is to maintain the overall capital of the banking industry at levels approximately equivalent to those that exist under the Basel Accord today. To ensure that overall capital in the banking system does not fall, the Committee has proposed the use of a minimum overall capital floor for the first two years following implementation of the new Accord.
    While the OCC supports a temporary capital floor, it does not believe that a reduction in minimum regulatory capital requirements for certain institutions is, in and of itself, an undesirable outcome. A drop in required capital is acceptable if the reduction is based on a regulatory capital regime that reflects the degree of risk in that bank's positions and activities. But, we are not yet at the point where we can really make a confident judgment about the impact of Basel II on capital levels. QIS-3, the latest qualitative impact study, was based on an incomplete proposal and was applied by the banks without any of the validation or control that would be present when the new regime is in full force. Thus, an effort to calibrate new capital requirements based on QIS-3 must confront great uncertainty. This uncertainty further illustrates the importance of moving cautiously before we incorporate Basel II into our domestic capital rules.
    In conclusion, as I indicated earlier, the OCC strongly supports the objectives of Basel II. This summer, the OCC and the other banking agencies expect to seek notice and comment from all interested parties on an advanced notice of proposed rulemaking that translates the current version of Basel II into a regulatory proposal. If we determine through our rulemaking process that changes to the Basel proposal are necessary, we will press the Basel Committee to make changes. We further reserve our right to assure that any final U.S. regulation applicable to national banks reflects any necessary modifications. Given the importance of this proposal, we need to take whatever time is necessary to develop and implement a revised risk-based capital regime that achieves the stated objectives of the Basel Committee, both in theory as well as in practice.
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    Thank you very much.

    [The prepared statement of Hon. John D. Hawke, Jr., can be found on page 94 in the appendix.]

    Chairwoman BIGGERT. Thank you.
    Mr. Powell, you may proceed.


    Mr. POWELL. Thank you, Madam Chair and members of the Subcommittee.
    Since 1999, the Basel Committee has worked hard to develop a new international capital framework referred to as ''Basel II.'' I entered this effort late in the game, having joined the FDIC eighteen months ago, and I am grateful to my fellow supervisors and their staff for the efforts to get us where we are today.
    Bank capital is critical to the health and well-being of the U.S. financial system. An adequate capital cushion enhances the banks' financial flexibility and their ability to weather periods of adversity. The conceptual changes being considered in Basel II are far-reaching. For the first time, we would create one set of capital rules for the largest banks and another set of rules for everyone else. Under the proposed new Accord, large banks will feed their internal risk estimates into regulator defined formulas to set minimum capital requirements. Under the new formulas, minimum capital requirements for credit risk would tend to be reduced, with additional capital being held under a flexible operational risk charge.
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    Admittedly, the existing capital rules for the largest banking organizations have not kept pace with these institutions' complexity and ability to innovate. Basel II intends to align capital with the economic substance of the risks large banks take. That is a worthy goal. Nevertheless, before regulators and policymakers embrace Basel II, the FDIC has concluded that three critical issues need to be addressed.
    First, minimum capital requirements must not be unduly diminished. Lower capital requirements for credit risk, together with a set of more flexible capital charges imposed by supervisors, may work well in theory. Experience demonstrates, however, that it is difficult for supervisors to impose substantial capital buffers in the face of stiff bank resistance, especially during good economic times. Substantial reductions in minimum capital requirements for the largest U.S. banks would be of grave concern to the FDIC.
    Second, we must be satisfied that the regulators can validate the internal risk ratings. By allowing the use of banks' internal risk estimates, Basel II represents a significant shift in supervisory philosophy. This new philosophy demands that we have in place uniform and consistent interagency processes that are effective in assessing whether the banks' internal estimates are reasonable and conservative. These processes are being developed by the agencies, but the work here is not final.
    Third, we must understand and assess the competitive impact of Basel II. Basel II will most likely be mandatory only for a group of large, complex and internationally active U.S. banking organizations. This mandatory group of institutions does not include numerous large regional banking institutions, as well as thousands of smaller community-based banks and thrifts. If Basel II provides the largest U.S. institutions some material economic advantage as a result of lower capital requirements, the ''non-Basel'' institutions may find themselves at a competitive disadvantage in certain markets. This ''bifurcated'' system raises the concerns of competitive inequity between these groups of banks.
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    banks themselves are best equipped to evaluate these issues. We regulators, in turn, must provide them with straightforward dollars and cents information about the Accord and the capital they or their competitors may be required to hold.
    The FDIC will work with our fellow regulators to address these issues in the months ahead. Presuming these threshold issues are satisfactorily resolved, numerous Accord implementation issues still need to be decided. I will touch on two of them in my remaining time. To fully adopt the internal ratings-based approach proposal in Basel II, banks must make significant investments in staff expertise, internal controls, and make the necessary structural and culture changes. Qualifying for and living with Basel II will bring complexity and burden. Of course, a degree of regulatory complexity is unavoidable as banks seek to have capital tailored to their individual risk profiles. But these burden considerations, and the desirability of testing the waters with the new Accord, suggest that the universe of ''Basel II banks'' initially will, and should be, relatively small.
    The proposed capital charge for operational risk has attracted much discussion. Bank failures related to operational risk can be traced overwhelmingly to one common theme-fraud. This is certainly part of the reason banks hold capital. Whether the operational risk charge is called Pillar I or Pillar II is not of critical significance to the FDIC, provided the regulators implement this approach in a commonsense, flexible manner.
    Finally, in implementing the Accord, let us not overlook the importance of credit culture and the virtues of conservative banking. The Basel II internal risk estimates are likely to be only as robust as the credit culture in which they are produced. Rigorous corporate governance structures, effective internal controls and a culture of transparency and disclosure, all play an important role in ensuring the integrity of the banks' internal risk estimates. It will be important for supervisors not to place excessive reliance on quantitative methods and models. Models can be wrong and losses can depart from historical norms. That is why we need a margin for error. To repeat an earlier point, that is why we need capital.
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    Thank you.

    [The prepared statement of Hon. Donald Powell can be found on page 145 in the appendix.]

    Chairwoman BIGGERT. Thank you very much. We will now have questions. I will yield five minutes to the chairman of the Financial Services Committee, Mr. Oxley.
    Mr. OXLEY. Thank you, Madam Chairwoman. I appreciate that.
    Gentlemen, Mr. D. Wilson Ervin, representing Credit Suisse First Boston, will be testifying on the second panel. Always a problem with the second panel is that members are distracted and so forth, so I was looking over his testimony and he had some very pointed criticisms of Basel II and I thought maybe I would bring them up with you, and see how you respond. While giving some very good support and praise for the work of this project, he cites four macro issues that arise out of the proposed accord that he has some problem with. I would just like to ask each one of you to respond to those specific macro concerns.
    The first one is, as Mr. Ervin says, the current Basel proposal is too complex, too costly, and too inflexible to provide a robust, durable framework for bank supervision going forward. Implementing the proposed accord may have the effect of freezing the development of good risk management and locking it into an ''early 2000'' mindset. I am not quite sure what that means, but that is a good place to start.
    Dr. Ferguson?
    Mr. FERGUSON. Certainly. I appreciate your giving me a chance to respond to this. First, on the question of complexity, the answer is Basel II is more complex than Basel I. There is no doubt about it. The question of why it is complex is the key issue here. It is complex because Basel I was a one-size-fits-all, very simplistic approach that did not reflect or does not currently reflect the way the largest banks manage their capital and manage their operations. As we went forward with Basel II, in consultation with the industry, as we came out with a variety of proposals, many in the industry asked for a slightly different approach, more flexibility, different options. What one ended up with was indeed a system that moved from one-size-fits-all to a system that is appropriately much more risk-sensitive, that reflects the range of activities that banks undertake, the range of risks that they take, and consequently is more complex.
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    So the question is not that it is too complex, but I think it is complex because it reflects the complexity of the banking industry.
    Mr. OXLEY. What about too costly?
    Mr. FERGUSON. Second question, costly. I think of cost in terms of the cost-benefit analysis. There are two ways that I have thought about this cost problem over the last year or so when I have been actively involved in this hands-on way.
    First, many of the largest institutions are already going down this path. As I have gotten involved with this, as I have worked with the staff, I have discovered a large number of our large and complex institutions already approach risk management in a way that is quite similar to what Basel II is doing. They need some incentive. They need some encouragement. Some are laggard, which is one of the reasons why going in this direction is appropriate, but they have found it in their own business interest to start to manage in a way that is quite consistent with what Basel II has asked for.
    The second question with respect to cost is what is the benefit that one gets out of it, because it is more costly than simplistic approaches, but on the other hand there are clear business benefits, and I think national benefits to having banks that are managed in a way that focuses much more on the variety of risks that they face and the various portfolios, and recognize that there is more than a one-size-fits-all approach. So I look at this in terms of cost-benefit, not just being too costly.
    Mr. OXLEY. Too inflexible?
    Mr. FERGUSON. I think that is also a misunderstanding. As I tried to indicate in my opening remarks, one, I think Basel II and the interaction and development of Basel will allow for an ongoing improvement with respect to Basel. As my colleague Mr. Hawke indicated, the expectation would be that this would be implemented originally in the very first part of 2007, but there would be ongoing review through 2008 and 2009. So there is a chance to continue improvements. Obviously, through both Pillar I, Pillar II, and Pillar 2I, as new risk management techniques take hold, and there are new ways of estimating some of the important parameters, that the business community developed, the banking community develops, or that we develop, those can and will be reflected in the capital requirements. All we are asking banks to do is estimate some parameters, but the process by which they estimate them, as long as we as regulators can validate them, can and should evolve over time with the best risk-management technology and techniques that emerge as we go into the 21st century.
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    Mr. OXLEY. Thank you, Dr. Ferguson.
    Let me just go to Mr. Hawke. Complex, costly, inflexible?
    Mr. HAWKE. Mr. Chairman, here on the table is the current version of Basel II. It is infinitely more complex than it needs to be. It is not complex simply because we are dealing with a complex subject. It is not only complex, it is virtually impenetrable. I defy ordinary people to get past page three or four of most of the parts of this document.
    Mr. OXLEY. Ordinary people do not read that stuff.
    Mr. HAWKE. Ordinary people called bank examiners have to apply it.
    Mr. OXLEY. You are calling bank examiners ordinary people?
    Mr. HAWKE. That is not a slur.
    It is complex because it reflects a mindset on the part of a controlling view in the Basel Committee that this needs to be a highly prescriptive document that addresses every nicety and every aspect of capital regulation. Every loophole is plugged. Every nuance is addressed. It reflects a pathological aversion to the exercise of supervisory discretion. That is why it is as complex as it is. It does not need to be this complex, and I have argued this point in the Committee for the past four years.
    Second, as to whether it is too costly or not, I think that depends on what the final impact is. If the capital of banks is really reduced to a point where it is better reflective of risk and that reflects a capital saving, then the cost may be entirely justified.
    And, quickly, as to the final point, whether it locks us into a year 2000 approach to risk measurement, I have thought for a long time that that was a danger. We have in a sense here a governmentally dictated approach to capital measurement. It is an approach that has an awful lot to say for it. But it is our approach, and banks are going to have to make an investment in implementing the approach that we put out there in final form. That does run the risk of inhibiting the development of new and better risk measurement systems, because banks will already have made the investment in the system that we have told them that they are going to have to follow. So I think that is a danger.
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    Mr. OXLEY. Thank you.
    Chairman Powell, could you give us a succinct Texas response to those three issues?
    Mr. POWELL. First of all, I have never met a normal examiner.
    I am just kidding. Again, being a former banker, I have never seen a regulation that was not complex. They tend to be all complex. I think there is a need for a certain complexity in the regulations. Having said that, I think as it evolves over time, the complexity is diluted to some extent in real practice. I think regulators have a history of working with institutions to resolve complexities. So I am not as concerned as much about the complexity as some, and perhaps it should be complex. I am more concerned about making sure that Basel II maintains adequate capital ratios. I think it is necessary. I think it is important when we are addressing deficiencies within the system. We must and should have better risk models. Whether those models are more complex, again, depends upon the view. But my overriding concern is that those models do not produce watered-down capital requirements of these that are in existence today.
    Mr. OXLEY. Thank you.
    Thank you, Madam Chairwoman.
    Chairwoman BIGGERT. Thank you.
    Mrs. Maloney, the ranking member, is recognized for five minutes.
    Mrs. MALONEY OF NEW YORK. I defer to the ranking member, Mr. Frank.
    Mr. FRANK. I thank the gentlewoman. I want to say, as I read this, part of what I get is that when people have said this should have been Pillar II instead of Pillar I, the defense in part is yes, but it is a Pillar I that looks like Pillar II. Well, if it looks like Pillar II, why don't we make it Pillar II. Mr. Ferguson?
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    Mr. FERGUSON. Again, a good question. Let me explain what it does do and how it is different from Pillar II. The importance of Pillar I falls into three categories, Congressman Frank. One is transparency. Under Pillar I, you disclose the capital that you are holding for a particular purpose.
    Mr. FRANK. Let's do these one at a time. Is there anything that would stop you from saying it is Pillar II, and as a transparency requirement, that as part of your administering it as a Pillar II, you would require that that amount of capital that you can show be made public?
    Mr. FERGUSON. There is nothing that stops us from going that route.
    Mr. FRANK. I just like to do things one at a time. It seems to me on transparency we have got a tie.
    Mr. FERGUSON. Absolutely right. Let me go to Pillar II, the other elements of why Pillar I is important. Pillar I allows for more rigor in this process, and I frankly have to disagree with some of the tone I have heard from the subcommittee that this is very hard to quantify. There are a number of banks that already are doing risk management and risk measurement in the area of operational risk. Though not as quantifiable as credit risk, I would admit, it is more than just sort of a vague gut instinctive feel. Through the use of databases and a variety of statistical techniques, which I would admit are complex, it is possible to do a better job of quantification than perhaps some might think, and there are banks that are doing that.
    Now, the difference between Pillar I and Pillar II in that regard is that the enforcement of a rigorous, more easily quantifiable, more verifiable approach works much better under the authority of Pillar I than the give and take, back door, quiet negotiation that exists under Pillar II.
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    Mr. FRANK. I appreciate that. Let me ask you, then, about this one. The banks that have quantified this, do you think they have on the whole come up with adequate capital set asides to meet those risks under the current situation?
    Mr. FERGUSON. The answer is I believe that is probably true. Let me elaborate. It is not just the banks that have quantified it in the way that we are thinking about.
    Mr. FRANK. I understand. I appreciate it. You know, this is not the easiest stuff in the world, so you have got to be a little bit compassionate towards some of us who are learning this because this is our job. To be honest, I do not expect this to be coming up at a town meeting, even if I had one, and I do not have one. I need to go one at a time here. I am just talking now; you said that some people have said that it cannot be quantified, and you have said it can be with a reasonable approximation. We know you do not get precision.
    My question, then, is very specific. To the extent that you are familiar with those that have quantified, have they tended then; have they put up enough money? The second part of that question would be this, under the Pillar I approach, would the amount of capital a bank would be required to put up approximate what they are now doing—those that have quantified?
    Mr. FERGUSON. You have led me to the point that I wanted to get to anyway, thank you very much.
    Mr. FRANK. If I got to where you wanted to go, maybe it was not such a good way.
    Mr. FERGUSON. Two responses to your two questions. First, the answer, as I quickly check with staff here, yes, we would say that those that have been on the cutting edge in terms of using a more quantified approach to operational risk have ended up with a result that seems to us to be within the ballpark of reasonableness; point one.
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    Point two, one of the major issues that one must understand in this discussion is that many of the banks that are most vociferous in opposition, and in fact the vast majority of U.S. banks, hold excess regulatory capital. The total amount of capital that we think would be required by quantifying op list would not go up. The difference would be in transparency and disclosure, because it would become clearer that they are holding some of that capital that they now describe as excess specifically for operational risk.
    Mr. FRANK. But we have agreed that you could under a Pillar II approach deal with that by requiring that.
    Mr. FERGUSON. Right, but I am responding to your question about whether the total amount of capital would have to go up, and the answer is no, the total amount would not.
    Mr. FRANK. Let me ask you one last question, and then I want to turn to the others briefly. The people who make the decision to avail themselves of this capacity, the storage. We are talking here about people who decide they are going to have one of these banks be the place where they store stuff. My impression is we are not talking here about individual consumers, but entities that are themselves sophisticated institutions. Is that generally correct?
    Mr. FERGUSON. Yes, generally speaking.
    Mr. FRANK. Okay. Then here is my question, because I raised the question in some informal conversations, why we could not just do it with publicity, et cetera, and people said, well, why doesn't that work for deposit insurance, and does that mean you have to have deposit insurance. It was a reasonable question. I thought about it, and of course part of the problem is that many of the people who make a decision to put their accounts in a bank are unsophisticated consumers or they may be people who are sophisticated about some things, but the transactions costs of trying to figure out what was a safe bank and what was not would be impossible. I put myself in that category. I want to put my money in a bank. I do not want to have to check all these other things.
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    But with regard to the people who avail themselves of this particular service, it would seem to me that if you went ahead and used the transparency authority you had and published how much capital they had, et cetera, made them publish it, and if in fact you thought it was inadequate and said so, that given the sophisticated nature of the consumer in this case, that that would be a pretty good protection. What is the matter with that?
    Mr. FERGUSON. I think that it does not reflect two major points here. One is, as I have said, the negotiation and the discussion between the regulators and the institutions is one in which having the Pillar I capability allows us to get to reasonable answers.
    Mr. FRANK. One point at a time. Wouldn't the fact that you might issue a statement saying you thought that the amount they set aside was inadequate; would not that be a pretty effective tool for you to use, given the again sophisticated nature of the consumer?
    Mr. FERGUSON. That would be a dramatic change in the relationship. One of the things that happens in supervisory relationships is that by and large, unless an institution goes to the point that we need to have a public memorandum of understanding or a cease and desist order, we keep confidential the regulatory information. For example, we do not publish the so-called CAMEL rating. So to move into a position where in lieu of using Pillar I we are in a name-and-shame mode, a whistleblowing mode, changes the confidential relationship that we normally have with institutions. I would prefer not to do that for the sake of operational risk.
    I think this Pillar I approach allows the right kind of discussion and the right kind of transparency, without putting us in the awkward position of disclosing confidential information about how we consider banks in terms of, if you will, a rating. That is the implication of what you just said, and it is quite a change from the way that we normally deal with banks. I do not think you really want us to go down that path.
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    Mr. FRANK. No, my feeling is that the fact that you might do it would give you as much leverage as you needed.
    Mr. FERGUSON. Yes, but what I have said is that the reality is that the banks know that historically we have not done that, and in fact we are by our own rules and regulations—
    Mr. FRANK. You historically have not given them a charge for this kind of risk, either. The whole purpose of this is to change the history.
    Mr. FERGUSON. Let me respond to your other question, which is whether or not sophisticated counter-parties would have a general sense. The answer is that even for sophisticated counter-parties, they may have a general sense of management, but in fact they really cannot look into these opaque institutions with the same clarity that the management itself has, and indeed in many cases the management itself uses. One of the things that you must understand is that Pillar I, or this entire approach, so-called advanced measurement approach, depends on the bank's management measurement tools with respect to operational risk. In some situations, we are leveraging their strengths and their internal view to develop capital, as opposed to only on externals.
    Mr. FRANK. That is another question. If the bank does not have good internal management, then Pillar I is not going to work so well with them?
    Mr. FERGUSON. No. The point of Pillar I, and using all three Pillars in this case, is to provide the banks with the right set of incentives to manage as we know the leading edge banks can do, and as we know many of the other large banks are starting to do already, which is not; while it is a relatively nascent science to compare their credit risk, this is not something which the people on panel two or any other leader of one of the major banks has a complete lack of experience or exposure. So we are trying to give them the incentive to keep going down a path that we, and I would think they, should be on.
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    Mr. FRANK. I appreciate it. I have taken too much time. I have some other questions, but I will submit them.
    Chairwoman BIGGERT. We will have another round.
    Let me ask the next question, and I will direct it to the other two gentlemen, although it really does apply to all three of you, but we can come back to that. I really do not want the answer; it is a question that is similar, but there are other things in here that I would like you to address, rather than what has just been talked about.
    It is my understanding that the operational risk will include a charge for the potential costs associated with U.S. tort liability, discrimination, suitability and similar laws, most of which do not apply in the European Union or in Japan. Would not such a capital charge have an adverse competitive impact on U.S. banks, and perhaps reduce compliance efforts? I wonder if you could give the subcommittee any examples of where the costs associated with compliance or litigation have resulted in a bank failure. If not, why impose a capital charge related to them? Would more effective supervision then enhance both the social policy goals of these rules and reduce the operational risk?
    Mr. Hawke?
    Mr. HAWKE. I am frequently asked the question about whether operational risk events have resulted in bank failures. One has to scramble to try to find examples of that. There are probably one or two, but there is no question that operational risk events have resulted in significant loss. I do not think the test of failure is necessarily the right one.
    Differences between the United States and foreign countries, in things like tort liability may well exist, reflecting differences in risk between banks operating in those jurisdictions. If our banks are subjected to greater potential risk because we have a more refined system of tort liability, that is a real risk that they face. It may indeed result in some kind of competitive inequality.
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    Chairwoman BIGGERT. Mr. Powell, do you have anything to add?
    Mr. POWELL. I would not have anything to add except this. While Comptroller Hawke indicated that he is not sure that should be the test as it relates to operational risk, I would agree with him. We would be hard-pressed to find that institutions have failed on a regular basis because of operational risk. Some of these operational risks are insurable. One can purchase insurance for that risk.
    Having said that, clearly operational risk is very real in the marketplace, and capital should be allocated. We at the FDIC believe that there should be supervisory flexibility in addressing operational risk. As we indicated, we really have no preference whether it is in Pillar I or Pillar II.
    Chairwoman BIGGERT. Then saying that, is there any flexibility in Pillar I for operational risk?
    Mr. HAWKE. Madam Chairwoman, I think the important thing to understand about operational risk is that there are at least three components that need to be addressed in assessing it. One is the nature of the risk; another is the quality of the controls that the bank has to address the potential risk. The third would be the quantification of that risk and the translation of that quantity into some kind of capital charge.
    All those things would have to be done whether this was nominally under Pillar II or Pillar I. I have argued in the Committee consistently that this should be a Pillar II exercise because so much of it is subjective in nature: the evaluation of internal controls, the evaluation of the nature of the risk. But ultimately, it comes down to a question of quantification and determining how much capital should be held against those risks.
    I think that the advanced measurement approach that we have developed, which is nominally a Pillar I approach, takes into account an appropriate degree of subjectivity. It is still a work in progress. We still have to make sure that it works right, that we are approaching the quantification issue, and the capital charge that results, in an appropriate way. But from my point of view, the good thing about the AMA approach is that it infuses a substantial amount of supervisory discretion into the process, the same kind of supervisory discretion we would have had if this had been under Pillar II.
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    Chairwoman BIGGERT. Thank you. My time has expired. The gentlewoman from New York?
    Mrs. MALONEY OF NEW YORK. Thank you.
    Earlier I wrote Comptroller Hawke and others about my concern about the global competitive nature of the financial services industry, and the concern that American institutions not be placed at a disadvantage. He wrote back, and I would like to place both letters in the record, and expressed some of the testimony that he is giving today on the Pillar I versus Pillar II, for the charge or operational risk. He has testified that the advanced measurement approach appears to add more flexibility. I would like to put his letter in the record. I think it is very clarifying and important.
    Chairwoman BIGGERT. Without objection.

    [The following information can be found on page 171 through 173 in the appendix.]

    Mrs. MALONEY OF NEW YORK. I would like to follow up on what you are saying on how in the world do you resolve the differences when you have a disagreement, as you have expressed today, between Pillar I and Pillar II, for the charge for operational risk? When we get to rulemaking, there will be differences of opinion, and the OCC has oversight for national banks, the Fed for holding companies; if you disagree, how do you resolve it? Who has the final trump card?
    Mr. HAWKE. We spend a great deal of time trying to work out interagency differences. I think that effort has been enormously successful. We have common objectives and have worked very well together. I do not anticipate that that will change going forward.
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    As I mentioned in my testimony, the OCC has the sole statutory responsibility for determining capital requirements for national banks. In the theoretical event that we do not come to closure with our colleagues at the Federal Reserve on an approach, national banks would be subject to whatever regulatory requirements we imposed on them. The Federal Reserve has authority to set the capital requirements for holding companies and non-bank subsidiaries of holding companies, but that ability to set holding company capital is not intended to supplant the judgment or authority of the primary supervisor with respect to the banks. Holding company capital is intended to protect the bank from the holding company, not to protect the holding company from the bank.
    I think our respective roles are pretty well spelled out by statute, but I do not anticipate that if this process works the way it should that we will end up having significant differences.
    Mrs. MALONEY OF NEW YORK. Comptroller Hawke, why is a capital charge being proposed for operational risk when there is no comparable one for interest rate risk? While significant problems remain quantifying and measuring operational risk, many of which you have pointed out today with your colleagues, interest rate risk is priced daily by well-understood methodologies. So why omit interest rate risk from Pillar I, when it has been the cause of bank failures, while subjecting operational risk to it? Why are we taking that away from Pillar I when we know there have been bank failures, and you testified you do not even know if there have been bank failures in operational risk.
    Mr. HAWKE. That is a question that got raised and negotiated very early in the Basel discussions. There were a number of us in the U.S. delegation who felt that interest rate risk ought to be included in Pillar II. As I said, I felt that operational risk ought to be included there as well. In early negotiations in the Basel Committee, it was agreed that interest rate risk would be treated as a Pillar II item, with attention focused on outliers in the spectrum of interest rate risk.
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    Mrs. MALONEY OF NEW YORK. Why shouldn't it be in Pillar I?
    Mr. HAWKE. I think one can make an argument that it should be in Pillar I. It is probably easier to quantify.
    Mrs. MALONEY OF NEW YORK. Much easier to quantify than operational. So why is it not in Pillar I versus operational?
    Mr. HAWKE. Interest rate risk is a lot easier to deal with. banks deal with it all the time. The concern with respect to interest rate risk was not the run-of-the-mill kind of risk, but the risk presented by outliers who have significant mis-matches and different kinds of portfolios. It was thought that there was more room for supervisory discretion.
    Mrs. MALONEY OF NEW YORK. So the United States more or less wanted it in Pillar I, and the foreign countries did not; is that it?
    Mr. HAWKE. No, the other way around. We wanted it in Pillar II.
    Mrs. MALONEY OF NEW YORK. You wanted it in Pillar II?
    Mr. HAWKE. That was one that we won.
    Mrs. MALONEY OF NEW YORK. You won that one. Okay.
    One of the things that I am concerned about, and this is something that the ranking member mentioned and the chairman mentioned, and everybody on the panel both sides have mentioned our concern about how are we looking out for financial institutions, American banks, to make sure they are not placed at a competitive disadvantage? I would like to hear from all of you. What are you doing to make sure that we are not placed at competitive disadvantage? I can see a lot of things in this that could hinder the competitive ability of our banks. So I would want to know, do you have a formal procedure where you make sure that we are not in any way hindering American banks in the competitive market here or place unfair charges and burdens on them?
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    Chairwoman BIGGERT. Briefly, please.
    Mr. HAWKE. Let me say that the very purpose of Basel II was to try to improve competitive equality among internationally active banks since it was felt that Basel I left too much room for competitive inequalities to emerge. So in terms of competition and competitive equity among internationally active banks, that has been the name of the game. As I said, I think that some issues, like the very complexity of the process itself or the rule itself, work toward competitive inequity because of the differences in the nature of the supervisory systems between countries.
    Mr. FERGUSON. If I may address that issue as well, a couple of things. One is, I believe that the strength of the U.S. banking system deals with the fact that we have very strong capital, among other things. If you compare the U.S. banking system to that in Europe and certainly in Japan, I see no competitive weakness at all in the U.S. by having strong capital. I think just the opposite.
    Second point, as my friend Jerry Hawke has pointed out, the name of the game here and the reason to have these three Pillars and to have transparency et cetera is to allow greater competitive comparisons across institutions. That is one of the reasons why we have entered into this, so as to reduce competitive inequity.
    The third is we clearly have in a number of places decisions that a bank from wherever they may be operating in the U.S. will be required to live by some of the elements of the accord that we are developing here as part of national discretion. So we have managed with this head-to-head competition in some of these various portfolios to confront the issue directly.
    I think we should not make the mistake of believing that having strong, well-capitalized banks with strong risk management weakens them in a competitive sense, because the recent history and long history indicates that the U.S. banking system is extraordinarily competitive vis-a-vis many others who have, frankly, exercised a lot more forbearance than we have. So I think the strength of our system comes from just the kind of regulation and the kinds of controls that we are discussing here today.
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    Mrs. MALONEY OF NEW YORK. My time is up.
    Chairwoman BIGGERT. Mr. Kennedy, the gentleman from Minnesota.
    Mr. KENNEDY. Thank you, and thank you, panel, for your testimony. I would just like to continue on that dialogue on competitiveness. I will grant you that we have the world's best banks and the world's best regulators, but when I look at that, how do I make sure, and does Basel II make us more likely to have uniformly applied regulations among the regulatory bodies in other countries? You talk about this, how it gives you more flexibility. Well, flexibility gives me concern if that means that the other regulators in other countries do not apply the same levels of standards that we do, that we put in that way American banks at a competitive disadvantage.
    Mr. FERGUSON. I think there are three components to my answer to your question. First, it goes back to the differences between Pillar I and Pillar II, et cetera, where indeed Pillar II is by definition one that creates more of a negotiation. It is less transparent, and therefore there is more regulatory discretion. Consequently, the need to put things such as operational risk, I believe, in Pillar I where there is a more rigorous framework, yes, built around internal management and measurement approaches, but with a more rigorous framework and more rigorous outline, point one.
    Point two, is there are three Pillars here. One of them has to do with transparency. One of the best ways I believe to ensure the kind of international equality that you are discussing is to have the banks that are under Basel II or will be under Basel II required to disclose important parameters, not the ones that are of competitive sensitivity per se, but the ones that allow best comparisons across institutions in terms of the nature of their portfolios, the nature of their risk management capabilities so the counter-parties can look and understand a bit more about them.
    The third is that there is a structured process among the members of Basel II, of the Basel Committee. There is an accord implementation group that brings the regulators together to hold each other accountable for how this is being implemented. So that if we from the U.S. standpoint have a strong sense that some of our colleagues around the world appear not to be bringing the same focus, the same seriousness, we have this infrastructure, this communication technique through the so-called AIG, the Accord Implementation Group, that allows us to pressure them and to encourage them to take the same approaches that we are.
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    I think those three tools allow for a stronger sense of competitive equity, and a real sense of checks and balances in this process.
    Mr. HAWKE. I would endorse the points that Roger made, and add one further point that continues to trouble me in the area of competitive equity: that is, the vast differences in the nature of supervision. As I said in my testimony, we have in our largest national banks 30 or 40 full-time on-site examiners. We are intimately involved with those banks. In banks in some other countries, an outside auditor may do a flyover once a year. There is a significant difference in the invasiveness, if you will, of supervision between the United States and other countries. Given that disparity, it is inevitable, no matter how good the mechanisms are that the vice chairman described, it is inevitable that there are going to be disparities in application. The complexity of the proposal adds to that potential.
    Mr. POWELL. I would just add one comment. We have been talking a lot about the international anti-competitiveness. I think it is important for us also to pause and think about the domestic competitive inequities, if they are in fact are there. That is the reason I think some of the issues that we will be talking about as we go forward will come out in the public comments. I, too, am concerned about regional banks and smaller institutions that might be disadvantaged by Basel II.
    Chairwoman BIGGERT. Thank you.
    Mr. KENNEDY. I would share that concern. I would just like to follow up. Your discussions of the regional concerns are shared with me when you have two different standards within the same country. But following up on the international side, in my years as chief financial officer, we would note significantly different responsiveness from a Japanese-style bank versus an American bank. One of my big concerns is the fact that the hangover from that period where we had excessive bad loans in the Asian countries that have not been written off; is this new accord going to help bring our Asian counterparts towards addressing those issues? Or do we have to look for other avenues to try to encourage that?
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    Mr. FERGUSON. I think that is again a serious question. One would hope that if this is indeed enforced, and if again the public disclosure part as well as the regulatory part forces banks around the world, including Japanese banks, to use these more sophisticated risk management techniques, that you will find less of this irrational pricing that you have talked about. One of the points that I have made often in discussions is that the international banks, particularly the U.S. banks, need not worry so much about strong regulation from the Fed or the OCC or the FDIC, as they need to worry about irrational pricing from competitors who do not have the same sophisticated approach to risk management capabilities as embedded in Basel II. So that hopefully would respond to some of your questions.
    If I could take one minute to respond to the question about domestic competitiveness, I think that is an issue that must be explored in the comment period. However, as I have said in my written testimony, there are a couple of reasons why I guess I have a little less concern than my colleague from the FDIC, Mr. Powell. The first is that smaller banks tend to have much more information about their local counter-parties than a large national bank that is not actively in that market. The large national banks tend to depend much more on models and the information that can run through models. We have not seen any sense in which small banks are at a competitive disadvantage today. They clearly have shown a great deal of strength because of their understanding of local market conditions.
    With respect to regional banks, the capital that matters is not the regulatory capital which we are talking about here, which is a minimum capital. It is economic capital. There is nothing in Basel that is going to change economic capital. It is going to make things more transparent, but not change the economic capital that is the factor that decides pricing. In places where economic capital, which by and large tends to be higher than regulatory, that will certainly be the case. In those few cases where economic capital is lower than regulatory capital, which is to say you have new techniques that have developed such as securitization, which clearly is an important part of the U.S. market, that already exists. Both larger banks and regional banks are both using these securitization mechanisms to maintain a relatively level playing field where regulatory capital was set too high and therefore there are new techniques.
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    So I would argue even in the domestic situation, while it is important to ask the question, as we will when we get into the ANPR process, the proposed rulemaking process, I see nothing here that immediately leads me to believe that the competitive status quo is going to be changed domestically because of these capital changes. There are a number of other reasons that I have given in my written testimony to deal with the competitive issue as well.
    Chairwoman BIGGERT. The gentleman's time has expired. The gentleman from Illinois, Mr. Emanuel is recognized for five minutes.
    Mr. EMANUEL. Thank you very much. Thank you for coming today.
    Obviously, since the decade and a half since the first Basel accord, it only makes sense to review, update and change given how much the marketplace has changed, and given that the first set of rules dealt with uniformity in the international market and tried to bring some safe and sound banking rules across borders and across markets. Although a lot of the questions have dealt with international competitiveness for American charter banks in the international market, I want to deal a little or ask some questions as it relates to how some of these rule changes have on a credit crunch. A lot of these discussions, as our ranking member made sense, you do not get questions like this about the Basel accord at town halls, which is true. You do get questions from a lot of folks about the notion that they cannot get access to capital at the very time they need capital. Some of the capital requirements here that have been discussed and recommended, my worry is they would actually have an adverse affect at the time in which you need capital, you cannot get it; at the time you do not need capital, you have access to it.
    So I would like to change just one; some of the rules and some of the suggestions here, the 20 percent operational risk capital charge, that also impact; it is also suggested that the flexible system that results in banks holding more capital in bad times and less capital in good times may adversely affect the economy by decreasing credit availability when it is needed most. I wanted to ask, as you go through the rulemaking process, what are some of the potential unintended consequences of new capital requirements as it relates to the flexibility that you are going to now ask for in the system, as it relates to the capital crunch in these times, whether the inverse effect?
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    In any order, go ahead.
    Mr. FERGUSON. I will respond first, and I am sure my colleagues will have other things to say as well.
    Obviously, we have been aware of the concern about cyclical implications with respect to Basel II. I have three or four components to my response. First is, I believe and I think we all collectively believe, that if you have a risk management system that is more risk sensitive, then what it will allow is for banks to make, and that sensitivity being measured over an entire cycle; I will not go through the technical reasons, but Basel II allows for that to be measured over an entire business cycle, not just in a short term-what you will find is that loan pricing is better. It reflects the risk. Therefore, what you will find is you have less of a tendency to make unreasonable loans during good times, and consequently are less surprised when loans fall off and profitability falls off in bad times. So there is a possibility that if you have much better risk management techniques and that plays through to better pricing, that you will get less of a cyclical swing, instead of more.
    The other point I would make is that we, being quite aware of some of these concerns, have also made a number of refinements and adjustments to allow for some of the measurements that the banks have to put in to again be less focused on a point in time in the cycle, and instead extend it out over a longer period of time. I will not try to go into all the technical details here, but we have been aware of that and have taken that on board.
    I would also say that one of the important changes under Basel II is that Basel I does not give banks credit for a number of things that matter and help to offset risk, that we plan to put into Basel II. For example, the current accord does not give any capital credit when collateral or other methods are taken to reduce risk and reduce the possibility of a loss given default. So that should also work to mitigate the possibility of having this be pro-cyclical. We will again continue to look at this as one goes into the comment period. I am aware of the comment, but I think the Basel Committee and the staff that support it, having heard the comment, have already undertaken two or three different efforts to reduce the risk of pro-cyclicality.
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    The other point I would really have to make is indeed I would think when times get bad, it is important for banks to take that on board and to recognize, as they have during every slow period, that it is appropriate to tighten credit to some degree; not to create a credit crunch, but to tighten credit to some degree. Most of the times when we have seen credit crunches occur historically, it is because there is a sudden and unexpected loss in profitability that has the risk of eating into capital. If we have gotten this right, we will find that you have fewer of those incidents occurring going forward.
    So I am aware of the procyclicality argument, but I think there have been a number of efforts made here to refine this, to minimize that kind of risk, and indeed to make this, if you will, a tool that allows good bankers to be better bankers during both the good times and also the bad times.
    Mr. HAWKE. Let me just answer briefly, unless you had another question. As a bank supervisor, not a central banker, I get a little bit nervous talking about procyclicality in the context of determining what the appropriate capital rules are for banks. I think that the best thing we can do to avoid a credit crunch is to make sure that our banks stay in sufficiently healthy condition to be able to make creditworthy loans when the opportunity arises, irrespective of what is happening in the economy. I think once we get into the business of trying to manipulate the capital rules to take account of changes in the macroeconomy, we run the risk of subverting the banking system to broader, perfectly legitimate concerns, but with the potential for effects that we see in some other countries where banking systems have been manipulated, where banking systems have become a disaster and have not been able to help in the recovery.
    So this is an area that I think we have to approach with great caution. As I say, my inclination as a bank supervisor is to look at capital rules without getting too concerned about procyclicality.
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    Mr. POWELL. I would tend to agree with Comptroller Hawke. I think the best defense against a credit crunch is a solid banking system. You build up capital in good times so that you can use it in bad times. I think there is a tendency for all bankers during nad times to impose additional requirements when we extend credit. But if in fact you have a healthy banking system, there is always going to be available credit.
    Chairwoman BIGGERT. The gentleman yields back. The gentlelady from California, Ms. Lee.
    Ms. LEE. Thank you, Madam Chair.
    Let me first thank the witnesses for your testimony and your presentations. I would like to ask all three of you just to give us some feedback with regard to Basel II as it relates to the real estate market. Some have said that it could negatively and adversely affect the U.S. real estate market. One, credit reallocations could adversely affect real estate development. Secondly, higher capital charges could result, well, would result in banks being forced to tighten their lending requirements, which of course then means that loans to anyone other than the highest rated would require banks to increase their capital services. So if banks were forced to retain more capital, it would be hard, I assume, to maintain some banks' current lending activities, with certain customers with lower credit ratings.
    Finally, I think one of the problems that many are raising with regard to the impact of Basel II on real estate development is that there would be fewer resources to purchase real estate loans from originators such as banks, leading to the tightening of credit in real estate markets. I would just like to get your feedback on those points, if in fact you see that as a problem or if in fact there are ways that it really is not a problem as you see it, with regard to Basel II.
    Mr. HAWKE. Let me take a crack at that. I think the Basel Committee has been very sensitive to the potential for inadvertent credit allocation as a result of what we are doing. One of the problems with the existing Accord is that the risk weight buckets that are used are so inexact in their determinations of risk that they do create opportunities to arbitrage the capital rules and that does have an effect on how bank credit is allocated.
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    On real estate specifically, we have an ongoing dialogue at present as to whether the approach to commercial real estate lending is the right one. Commercial real estate lending is not something that has been looked on in Washington with great favor because it lay at the heart of many of the bank failures in the late 1980s and early 1990s. The state of the art of commercial real estate lending has changed quite significantly since then. While there is an understandable skepticism and concern about the inherent safety of commercial real estate lending, we are inclined to think that we might not have to be as tough on that as the experience of a decade or more ago might suggest.
    Mr. FERGUSON. If I may respond to this as well, I think that Jerry Hawke is absolutely right in suggesting that the way to maintain healthy bank relationships in the context of real estate lending is to create, again, a system in which they really evaluate their risks appropriately and lend the right amount at the right price. No country is benefited by having excessive lending to any one sector, for sure. If Basel II works well, or any new capital approach works well, then what you will find is that indeed you have got a much better allocation of capital and that is what we want.
    Ms. LEE. But with customers with lower credit ratings?
    Mr. FERGUSON. That is the same issue. There is no different answer there. We have benefited in this country from the use of a number of new techniques that allow customers with lower credit ratings that have still good assets to get loans from banks. There is nothing that I see in Basel II that would put that at risk. I would think Basel II would encourage better pricing, for sure, which is again to everyone's benefit. There are other rules that obviously should deal with disclosure and transparency, et cetera. So I do not see any specific reason to worry about customers with the lower rating in some sense not getting the appropriate allocation at the appropriate price with respect to capital from Basel II.
    Mr. FRANK. Will the gentlewoman yield?
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    Ms. LEE. Yes.
    Mr. FRANK. A brief question; one of the things that strikes me, we have the three different agencies. Is the Fed the controlling agency here regarding America's position, and is that automatic because it is through Basel. If not, who decided this? How did we get to the point where it is the impression it has been the Fed's opinion that has governed. Why is that the case and is that something that; how does that happen?
    Mr. HAWKE. Congressman Frank, I have been sitting on the Basel Committee for four years, and I still do not understand how decisions are made. They appear to—
    Mr. FRANK. Well, is it automatic because it is central bankers? Did the president at some point designate a lead agency? How does this happen?
    Mr. HAWKE. There are four U.S. agencies that participate: the three of us and the Federal Reserve Bank of New York.
    Mr. FRANK. The Federal Reserve of New York is for these purposes the equivalent of the national agencies?
    Mr. HAWKE. Yes.
    Mr. FRANK. That is kind of like giving the Ukraine two votes, and Byelorussia votes at the United Nations, in 1945.
    Mr. FERGUSON. Perhaps I should respond to this.
    Mr. HAWKE. I am not going to touch that one.
    Mr. FERGUSON. Congressman Frank, the way this works is there are tough negotiations that occur among the three agencies. The people at this table get into negotiation. The people sitting behind us get into even more heated negotiations to try to develop a U.S. perspective. There is no lead agency here.
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    Mr. FRANK. Okay. Suppose there is a division, does the president ever decide?
    Mr. FERGUSON. No.
    Mr. FRANK. I have imposed on the committee's time, but this is one of the procedural things I think we ought to be straightening out. When we are talking about narrow technical things, it is one thing, but it does seem to me we probably ought to have some—
    Mr. FERGUSON. But there is no difference in this area, I would argue, than in any other area of regulation. The OCC has pointed out clearly that they have lead responsibility.
    Mr. FRANK. I differ with you, Mr. Ferguson, because each of you is supreme in his area of which bank, that you have certain basic things. But when we talk about an American negotiating position with other nations, it does seem to me we ought to have some more clarity as to who decides what that negotiating position is. Right now, apparently we do not.
    Mr. FERGUSON. The Basel Committee has historically been a committee that has brought regulators together to try to determine what we think is the best approach to regulations.
    Mr. FRANK. Right, but it does seem to me we ought to have somebody ready to make a decision.
    Mr. FERGUSON. Well, that is in part one of the reasons that we negotiate, obviously, is to make sure that we can come to you and give you our best advice. Clearly, one of the reasons in a democracy is that you have a comment period when you do—
    Mr. FRANK. Yes, but you also have somebody who finally—
    Mr. FERGUSON. And we have this kind of discussions to do that.
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    Mr. FRANK. I think this is something the committee will have to look into.
    Chairwoman BIGGERT. The gentlelady's time has expired. Let us do one more round. We do have another panel, but if we can ask succinct questions and get succinct answers, we can do another quick round. So I will start with a question.
    There is the extensive comment period for this proposal and for any rules that are coupled with several years of data collection. Do you think that the time frame for implementation of Basel II is a little unrealistic? It seems to me that the time frame assumes that there will not be a need for a fourth consultative paper. Is this a foregone conclusion?
    Mr. HAWKE. Not in my view, Madam Chairwoman. I think that the domestic rulemaking proceeding that we are going to be embarking on in the near future must be a fully credible and reasoned process that has integrity to it. That means that if we get comments back in that process from all sorts of potential commenters who have not yet had a chance to swing in on Basel, we have got to take them into account and evaluate them. That means that if our collective judgment is that there needs to be a fix, we have to either go back to Basel or let our colleagues on the Basel Committee know that there is going to be a U.S. exception on whatever the particular issue is.
    Chairwoman BIGGERT. Thank you. Mr. Powell?
    Mr. POWELL. I agree with the Comptroller.
    Chairwoman BIGGERT. Thank you for your short answer.
    Mr. FERGUSON. I agree as well.
    Chairwoman BIGGERT. Dr. Ferguson?
    Mr. FERGUSON. I agree. You got two short answers in a row.
    Chairwoman BIGGERT. The Federal Reserve recently issued a white paper on infrastructure security in which it calls for U.S. domestic financial institutions to increase expenditures on infrastructure protection. This, coupled with the fact that the Basel II proposal calls for a mandatory operational risk charge troubles me. It seems like the Fed is requiring domestic financial institutions to pay twice; once for improvements in the infrastructure and once for a capital charge. Can you explain for me why these seemingly divergent policies are coming from the Fed?
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    Mr. FERGUSON. I do not think they are all divergent. I think they are actually quite consistent. Let me be pretty clear about two things. One is there have been failures due to operational risk. Secondly, the Fed as the lender of last resort has had the largest single discount window loan ever because of an operational failure. It was $20 billion. It happened many years ago, but on a daily basis we have institutions that because of operational failure borrow from us during the course of the day. It is called a daylight overdraft.
    Thirdly, obviously as you well know, one of the recent times I was here was post-September 11, in which we lent several hundred billion dollars or over $100 billion. So we take operational risk quite seriously.
    Fourthly, there is nothing inconsistent about the two activities that you just alluded to. The point of the white paper is to encourage institutions to build appropriate backup capability so they can be more resilient, and so the financial markets can be more resilient. The point of Basel II is to say because these things may occur even if you are resilient, it is important to have capital. The way Basel II will work is that if a bank has managed its operations so that it has reduced some of the kinds of risks that we are concerned about under Basel II and operational risk, then that will come into play because the amount of capital they will be expected to hold will be lower. There will be offsets, for example, for insurance as well. So the two things I would say in lieu of being contradictory are much more hand-in-glove. They are really quite complementary.
    Chairwoman BIGGERT. And you do not believe that there is a pay twice?
    Mr. FERGUSON. No, I do not believe there is a pay twice.
    Chairwoman BIGGERT. Okay. Ms. Maloney, do you have another question?
    Mrs. MALONEY OF NEW YORK. Yes, I have a short question for Vice Chairman Ferguson. As you know, I have had a long interest in the Fed's role in the payment system. Federal law requires the Federal Reserve Board to calculate a private sector adjustment factor, a PSAF, to ensure that it is not competing at an undue advantage with private providers of payment services. How will the Fed adjust the PSAF for the operational risk capital charge banks will have to hold if the current version of Basel II is imposed?
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    Mr. FERGUSON. I cannot give you a specific answer. I can tell you in general how we think about this. We have in our system layers of backup that are similar to those that are expected in the private sector. In fact, I would argue that we have deeper backup than any private sector institution because obviously we have 12 institutions around the country and we work well together.
    One of the issues that is considered in the PSAF, as you know Congresswoman Maloney, is in fact questions of equity and what the equivalent equity in capital would be in the private sector. So obviously, we will consider that as we go forward. But let me reiterate the point I made earlier. I do not expect any bank to have an increase in the amount of capital being held because of this operational risk charge. There may be greater transparency. As Congressman Frank once said in another context, it is really moving capital from one drawer to another, from looking as though it is excess to being obviously associated with operational risk. That does not mean that the base of capital overall is going to go up, so I am not really sure that since there will be I do not believe brand new incremental capital in the banking system because of an explicit charge for operational risk, that we should have to change the PSAF. If that is the case, we will obviously adjust the PSAF so we stay in compliance with the Monetary Control Act.
    Mrs. MALONEY OF NEW YORK. I would like to follow up with Ranking Member Frank's question. Actually, I asked the same question earlier. How do you resolve differences? If you get back to us in writing. I have heard two descriptions of how you resolve it, and I am still not clear, so possibly if you could get back to us in writing.
    Very briefly, Vice Chairman Ferguson, I want to ask the same question actually I asked earlier. What is the necessity for a minimum capital charge or Pillar I treatment for operational risk, while you are not; why admit to interest rate risk from Pillar I when it has really been the cause of more bank failures, while subjecting operational risk to it. I do not understand why they are treated differently when interest rate risk is easier; there is a methodology that everyone understands and there are more bank failures from it. Why is that not getting Pillar I treatment?
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    Mr. FERGUSON. One of the things you have to understand is what the banks themselves do. banks themselves do operational risk as very large. We have taken a survey and we found that somewhere between 10 and as high as 15 percent of economic capital, which is not this minimum, but the economic capital that they hold, they often ascribe to operational risk. That is a significant sign that the banks themselves see operational risk as a real risk. We believe that implies and deserves treatment as this credit risk in Pillars I, II and III.
    The second point I would make is that banks actively manage interest rate risk on a daily basis. There are large committees called asset liability committees whose job it is to manage interest rate risk. What we have found over history is that they do a pretty good job of that. They are not perfect, and the reason that we, the U.S., have taken a consistent point of view that interest rate risk should be under Pillar II is that we have found that our discussions with them about how they manage interest rate risk under Pillar II has been quite sufficient in keeping that appropriately under control, and the banks understand that as well.
    So this is an area where in some sense things have worked reasonably well, and we believe that the status quo seems to be the best approach. That is sort of the whole goal of these various internal models, et cetera, that banks have. So I think you should think of these two things as being slightly different, and the approach to management being slightly different. Frankly, the incentives that are required are also slightly different, which is one of the ways I think op risk is very much like credit risk and deserves treatment across all three pillars.
    Mrs. MALONEY OF NEW YORK. I want to clarify my position, that I do not think that operational risk should be under Pillar I, but I appreciate your, or interest rate, for that matter. Would you like to; everyone has commented on it, would you like to comment on it too, Mr. Powell?
    Mr. POWELL. The FDIC position is we are not concerned with whether it is in Pillar I or II. We have no preference there.
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    Mrs. MALONEY OF NEW YORK. Okay. Thank you very much. My time is up.
    Chairwoman BIGGERT. Thank you. The gentleman from Massachusetts is recognized for five minutes.
    Mr. FRANK. Mr. Powell, you just said that the FDIC has no position on whether it should be Pillar I or Pillar II?
    Mr. POWELL. Right.
    Mr. FRANK. Mr. Hawke, does the comptroller of the currency have a position on whether it should be Pillar I or Pillar II?
    Mr. HAWKE. As I said, we have argued until we are blue in the face that it should be a Pillar II requirement.
    Mr. FRANK. Well, I am back to governance. Okay, I appreciate that. Okay, we have got four; first of all, I have to tell you, Mr. Ferguson, this is a profound issue for me. You three are appointed by the President of the United States and confirmed by the United States Senate. The New York Fed, as capable a technical institution as it is, is, as are all the regional banks, a self-perpetuating institution with no democratic involvement in the appointment of the head.
    Now, what we have is this, the four members; one prefers Pillar II, one is indifferent, and we have a strong national position in favor of Pillar I. I think the governance here is awry. How did this happen?
    Mr. HAWKE. I would not say that we have a strong national position in favor of Pillar I, Congressman Frank. The Basel Committee as a whole has taken that position.
    Mr. FRANK. The Basel Committee of the United States?
    Mr. HAWKE. No, the Basel Committee in Basel.
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    Mr. FRANK. Okay. But what about in the United States? I certainly got the impression that the United States position was strongly for Pillar I.
    Mr. FERGUSON. I think where we are on this is that we believe, all of us, and I know Jerry will speak for himself, but I think what I have heard him say is he has argued many times for Pillar II. There was not a consensus. Pillar I with this AMA approach seems to be a reasonable place to end up.
    Mr. FRANK. To whom?
    Mr. FERGUSON. I think to us.
    Mr. FRANK. Not to the FDIC, which is indifferent.
    Mr. FERGUSON. As I said congressman, Jerry will speak for himself.
    Mr. FRANK. He just did. He said he argued.
    Mr. FERGUSON. Pillar I is a reasonable place to end up.
    Mr. FRANK. Look, it is okay to have a position, but I do not think you are being totally straightforward about this. The FDIC did not have a position on Pillar I or Pillar II. The OCC was for Pillar II. And we wound up with Pillar I as a consensus. This is some consensus. I would like the power to impose such a consensus. I think clearly the Fed has become de facto the lead agency, maybe because we are dealing with international entities. I have to tell you, I think this requires some further thought on our process. To the extent that we are talking about fairly technical issues, that is one thing. For instance, one of the examples we are dealing with here; both my colleagues from California, Mr. Baca and Ms. Lee, raised small bank-big bank issues. To be honest, I think most people would rather have the FDIC and the OCC dealing with the small bank big bank issue than the New York Fed as an equal. I think these are legitimate governance issues that we have to raise.
    Nothing further for me. Mr. Ferguson, I will; oh yes, Mr. Powell.
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    Mr. POWELL. Congressman, I want to be sure that I am clear with you. While we do not have a preference whether this should be in Pillar I or Pillar II, we stress the need for supervisory flexibility in the implementation of it.
    Mr. FRANK. I appreciate that, and I think that frankly goes more for where we are, not where we were.
    Mr. POWELL. Right. I agree.
    Mr. FRANK. Yes, Mr. Hawke.
    Mr. HAWKE. I want to make clear that I support the AMA approach, even though I would strongly prefer Pillar II.
    Mr. FRANK. I understand that. You are no longer blue in the face, but you used to be, and I do think that goes to how we got there.
    Mr. Ferguson, just so that people do not think I am being entirely anti-Fed, I will refrain from asking you what you think about the President's tax plan. And I have no further questions.
    Chairwoman BIGGERT. The gentleman yields back. This will conclude the first panel. Thank you, gentlemen, so much for coming, and your expertise.
    The chair notes that some members may have additional questions for this panel which they may wish to submit in writing. Without objection, the hearing record will remain open for 30 days for members to submit written questions to these witnesses, and to place their responses in the record.
    We will now proceed with the second panel. If they could come forward and take their seats as quickly as possible, please.
    I would like to welcome the second panel First we have Karen Shaw Petrou, the co-founder and managing partner of Federal Financial Analytics, a privately held company that specializes in information and consulting services for financial institutions. Ms. Petrou spent nine years at Bank of America as an officer in their San Francisco headquarters, and then in Washington as the representative of the bank on Capitol Hill, and before regulatory agencies prior to starting Federal Financial Analytics.
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    Mr. Frank, did you want to introduce Mr. Spina?
    Mr. FRANK. Yes, I am very pleased that we are joined by David Spina, who is the chairman and chief executive officer of the State Street Corporation, which is Boston-based, actually headquartered in the district of my colleague Mr. Lynch who has joined us. He has been at State Street since 1969 and has had obviously a variety of positions there. He became CEO in 2000 and chairman in 2001. I am impressed when I read the information. I am impressed by two things, one that State Street was cited by Working Woman magazine as one of the top 25 companies for executive women, but even more important that Mr. Spina chose to put this in his biography. Frankly, he is a man of many accomplishments, in a wide range of things. I would note that he manages to expand two cultures. His undergraduate is from Holy Cross and his M.B.A. from Harvard, so he has a certain cross-cultural aspect. I do want to commend State Street also for its ranking from Working Women magazine and for singling it out, and for calling our attention for what seems to me a very significant issue. Thank you, Madam Chair.
    Chairwoman BIGGERT. Thank you. Next we have D. Wilson Ervin, who is managing director of Credit Suisse First Boston and head of risk management. He is a member of CSFB's risk committee and the leadership and performance committee. He joined CSFB in 1982 and has been involved in fixed income and equity capital markets, the Australian investment banking team, and the mergers and acquisitions group. Mr. Ervin received his B.A. in economics from Princeton University.
    Finally, we have Ms. Sarah Moore, executive vice president and chief operations officer of the Colonial Bank Group. She is a certified public accountant and worked for Coopers and Lybrand for nine years prior to her career with Colonial. She is a graduate of Auburn University with a B.S. in accounting.
    Just so that Mr. Spina will not feel left out about his college credentials, he has a B.S. degree from the College of Holy Cross and an M.B.A. degree from Harvard University, and was an officer in the United States Navy and served a tour of duty in Vietnam.
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    We are pleased to have this panel. As with the prior panel, if each of you could hold your comments to five minutes, and then we will have questions following that, and we usually get to any of the testimony that you did not get around to giving when you gave your testimony.
    Ms. Petrou, if you would proceed.


    Ms. PETROU. Thank you very much, Madam Chairman, and members of the subcommittee. I appreciate very much the opportunity to present the perspective of Federal Financial Analytics on the capital rule.
    My firm advises financial services firms with an array of concerns on the Basel Accord. We also advise the Financial Guardian Group, which is an organization of those banks particularly concerned with the operational risk-based capital sections in the accord.
    I would like if I can to step back from the complexity of the accord because so much has been done and the hard work on this massive accord that Comptroller Hawke lately waved as evidence of its depth and breadth. Economists have been focusing very hard on how it will work and what its impact will be and how these models may or may not be appropriate. I think this is missing one fundamental lesson from decision theory, which is you should maximize, do the best you can, not optimize as it is put, letting in a sense the best drive out the good. This decade-long effort since Basel I was put in place in 1988, and was finally effective in 1992, we knew then that the rule had some significant flaws. Mr. Frank has pointed to one of those; the exemption from the capital framework of short-term lines of credit. That was a compromise that was known early on that that was in fact a very problematic one, because it created artificial incentives to structure loans and credit arrangements in a way to arbitrage the capital rules.
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    You have heard a lot from many institutions complaining and asking questions about the Basel Accord, but I do not think many have questioned the fact that Basel II would fix this error, even though fixing it will cost them a good deal of money. That is one of the things I would argue needs to be done quickly. I think other things that are on the table on which all of the regulators who were here before you in the first panel agree can be done, should be done. Waiting for this complex accord to grind its way to consensus and conclusion on the 1,000 pages it has already hit and growing may delay urgently needed action that would protect financial systems here and abroad.
    It is essential, I think, that this action take place and take place quickly, because capital really does count. That message also gets lost in those 1,000 pages, but capital does count in the financial system in each of your districts. It is the fundamental driver of how profitability is measured. So a bank that has to hold more regulatory capital against a non-bank is less profitable in that business on the whole as another institution.
    Economic capital is one of the ways the market says you look risky to me; you need to hold more capital; we want the shareholder putting up money before I as a debtholder or another counter-party bank take a risk. It is very important that regulatory and economic capital incentives align properly. In fact, that is the objective which Basel II was originally aimed at correcting; ending this regulatory arbitrage where regulatory capital and economic capital differs. To the degree that Basel II leaves these differences in place in areas like operational risk, for example, new forms of regulatory arbitrage will be created.
    Similarly, to the degree that concern about rapid action to address areas where capital should drop; mortgages, small business loans for example, low-risk credit on which I think most people have agreed on about at least what the right initial risk-based capital rule ought to look like. You will create different incentives for different lenders to be in those businesses, to the degree that finally Basel II recognizes the appropriate economic capital for low-risk assets and drops it, the big banks using Basel II will get an advantage over the smaller banks still left out of the system. That could drive credit availability in the regions, as well as the ability of local banks to structure products to meet local needs.
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    This regulatory arbitrage issue is also apparent in some of the smaller details of the capital rules. The issue of commercial real estate has been mentioned. I would like to bring up another area which is the treatment of small and medium-size enterprises, SMEs in Basel talk. I like small businesses a lot. I own one, but small businesses can be very risky. The Basel rules define small and medium-size enterprises as companies with annual revenues of $50 million; not the mom and pop shops we are used to thinking about as small businesses in this country.
    The capital treatment for SMEs in the current version of Basel II is considerably lower than what most of analysts think is appropriate for economic risk. The reason is quite simple. Last year, Chancellor Schroeder threatened to take the Germans out of the Basel II negotiations unless the capital treatment for SMEs was fixed in accordance with German demands. That is a negotiating process. It is a legitimate one, but it is one where I think the Basel II rules remain potentially flawed. It is also an indication of the fact that this is a negotiation where the United States can, and when it is necessary to protect our interests, should intervene.
    The operational area is one where I think that should take place. We have had a very full discussion of that, and I know David Spina will touch on that in his testimony. It is an area where quick action on supervisory improvements is urgently needed. Everybody agrees that we learned a lot very much the hard way after the tragedy of September 11. On Tuesday, the Basel Committee put out, rule two for operational risk management. That now needs to be implemented, and implemented in a meaningful way, not just in the United States, but in Europe and Japan.
    We here have many tools to require appropriate supervision. I know Vice Chairman Ferguson cited some concerns that the U.S. regulators cannot enforce safety and soundness requirements. As a consultant in this field, I have never known them to be shy, nor should they be. Congress has given U.S. regulators many tools to enforce safety and soundness, and also to make the capital requirements count. One immediate step Basel II should look at is implementing comparable meaningful standards, including linking penalties to capital noncompliance. At the end of the day when the Basel II negotiations end, they will come back here. U.S. banks will be subject to unique sanctions if they fall below the sometimes arbitrary Pillar I thresholds. In the EU and Japan, nothing happens, we have seen that, and that is a central and immediate thing which Basel II needs to address.
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    The small bank issue is one I have mentioned briefly. There are some potential and significant issues there that need to be addressed and there can be rapid action on the agreed parts and sections of Basel II. Finally, the non-bank issue is an extremely important one, especially in the area of operational risk, where the banks that will be particularly adversely affected by operational risk-based capital, an arbitrary Pillar I charge, compete head-on with non-banks in the asset management and payments processing area.
    Chairwoman BIGGERT. If you could wrap up, please.
    Ms. PETROU. Excess capital is not that when it is put into the regulatory framework where these penalties would apply. It is very important that those capital determinations be made by the market.
    Thank you.

    [The prepared statement of Karen Shaw Petrou can be found on page 133 in the appendix.]

    Chairwoman BIGGERT. Thank you very much.
    Mr. Spina?


    Mr. SPINA. Madam Chair, members of the subcommittee, thank you for this opportunity to testify today and, in absentia, I would like to thank Representative Frank for his introduction earlier. Let the record show that my mother could not have done a better job. It was very nice of him to be so gracious.
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    I am chairman and CEO of State Street Corporation, a global financial services company chartered as a bank in 1792 in Boston Massachusetts. We provide services such as custody and safekeeping for investment securities, fund accounting for investment portfolios, and investment management for public and private institutions such as pension plans, mutual funds, endowments and the like.
    We believe the current Basel proposals will have significant negative competitive effects on U.S. banks, and if offered the option, we would choose not to opt into the new Basel operational risk capital framework. However, due to our significant position in our industry sector and the international nature of our business, we expect to be required by U.S. bank regulators to comply with Basel II.
    Before I summarize our objections, I would make clear that we agree with the Basel Committee that operational risk is a critical risk issue. We view the U.S. bank supervisory system as among the best in the world, which is an asset to U.S. banks. The strength of U.S. regulation, however, also creates challenges as we compete with institutions subject to less intensive regulatory supervision abroad. The U.S. supervisory approach to operational risk today is already working. It is treated as a Pillar II matter under Basel-speak today, and we believe that this provides a strong foundation for even better risk management practices going forward.
    The Basel Committee proposal would impose a new capital framework or requirements on banks based on statistical measures of operational risk. Using the Basel terminology, operational risk would fall under Pillar I, which establishes capital standards, as opposed to Pillar II, which addresses risks through supervision. The Basel definition of operational risk is a very, very broad definition, including nearly all risks inherent to conducting a business.
    Let me explain State Street's experience with operational risk. In the over 200-plus years that we have been in business, we have learned that relying on a capital cushion to absorb losses is a crutch, not a solution. Our focus is on rigorous risk management with a goal of reducing errors and avoiding losses. We minimize operational losses by making ongoing investments in systems, people and business continuity planning, and by ensuring our contractual arrangements clearly allocate risk between State Street and our clients. Our long-documented history of very low operational losses tells us that this approach works.
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    Operational risk, of course, is part of doing business for any company, but it is really an issue of earnings at risk, rather than capital at risk. In the very few highly publicized bank failures often attributed to catastrophic operational losses, no reasonable level of capital would have prevented bank failure. Adding a new regulatory capital requirement for operational risk will have a detrimental effect by creating disincentives for effective risk management and by creating an uneven competitive playing field for U.S. banks.
    Let me make four points very quickly. The Basel Committee's proposal creates a perverse incentive for banks to disproportionately focus financial and management resources towards meeting capital requirements, rather than on making essential investments in systems, people and business continuity planning. This is a little bit of the paying twice issue that Representative Maloney was referring to earlier.
    Second, the Basel Committee's proposal would disadvantage banks competing with non-banks. In the U.S., non-bank investment managers, fund accountants, payments processors and broker dealers are not subject to the current bank capital rules, nor will they be subject to the new capital requirements for operational risk. These non-banks include financial services firms that are well known; Firms like Fidelity Investments, our neighbor in Boston, SunGard, Merrill Lynch, and numerous others whose names you would recognize. The result under the Basel proposal is an unfair competitive disadvantage for banks competing with these non-bank financial firms.
    Third, the Basel Committee's operational risk proposal will hurt U.S. banks in the international marketplace. The proposal's untested quantification methods create a high probability of inaccurate capital assessments. Such errors disadvantage U.S. banks, which face far quicker regulatory response when we step over a regulatory line than we believe our competitors face in other countries. For example, U.S. banks are subject to the prompt corrective action required under FDICIA. It is prompt and it simply does not exist elsewhere in the world. In short, Basel creates a high risk of uneven application and enforcement, I think to the detriment of U.S. banks.
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    Finally, the banks that are most negatively impacted by the Basel Committee's proposed treatment of operational risk are what people often call trust banks; banks that specialize primarily in holding individuals' and institutions' assets as a custodian, fiduciary or investment manager. Disproportionately penalizing such banks with a new capital requirement could discourage competition and participation in such business lines, to the ultimate detriment of all investors.
    In summing up, I urge the subcommittee and the U.S. regulators to consider the potential detrimental effects of the operational risk proposal on U.S. banks, and instead to insist on the adoption of a rigorous supervisory approach under Pillar II of the proposed Basel framework.
    Let me just simply say thank you and stop there. I look forward to your questions.

    [The prepared statement of David Spina can be found on page 160 in the appendix.]

    Chairwoman BIGGERT. Thank you very much, Mr. Spina.
    Mr. Ervin?


    Mr. ERVIN. Thank you. Good afternoon, it is an honor to be here. My name is Wilson Ervin. I am presenting testimony today on behalf of Credit Suisse First Boston, and on behalf of our trade group, the Financial Services Roundtable.
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    CSFB is a major participant in global capital markets, employing approximately 22,000 people. We are headquartered in New York and regulated as a U.S. broker dealer and a U.S. financial holding company. CSFB is also regulated as a Swiss bank and will be required to use Basel II. Our implementation will be governed primarily by the Swiss EBK, but also by other regulators including the Federal Reserve and the UK FSA.
    As head of CSFB's risk management functions, my job is to assess the risks of our bank and protect our capital. That is a goal similar to many of the goals of bank supervisors. We agree with the importance of bringing the current regime up to date and fully support the objectives of Basel II. I personally developed tremendous respect for the regulators who have worked on Basel II, many of whom have been in the room today. They have addressed a great many challenging issues with stamina and sophistication, and they have been tenacious in trying to get to a best practice solution in each one.
    Yet while there is much to admire in the new rules, there are also many elements that raise serious concerns. We hope this committee, in conjunction with regulators and banks, will use this opportunity to improve the current proposal so that Basel II can live up to its original and very worthy goals.
    Today, I would like to focus on four macro issues that Chairman Oxley mentioned earlier. They are, number one, cost, complexity and adaptability over time; number two, pro-cyclicality or the risks that the new accord could actually deepen economic recessions; number three, operational risk; and number four, disclosure requirements.
    The first topic I would like to address is the high cost and complexity of the new rules and the effect this will have on whether the rules remain relevant over time. Most of this complexity can be found in Pillar I, which describes the recipe for calculating capital requirements. This is more than 400 pages, as you saw earlier today, and more than 12 times the length of the original Basel Accord. It is a normal result from this kind of process. Once you start trying to boil down the complexity of the real world into a series of mathematical formulas, it is very hard to stop halfway. I am concerned that this very complexity will make the rules difficult to update over time, and potentially lock us into that ''early-2000'' mindset regardless of what the future looks like.
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    An example of this complexity is the proposal for securitization, which is a common method for financing housing and credit cards. The draft proposal in this area alone runs to 40 pages and contains daunting formulas, as you can see from the examples submitted in annex one of my written testimony.
    The cost of implementation will be high. We estimate that approximately $70 million to $100 million in startup costs for our firm will be spent, even though we already use fairly sophisticated techniques for measuring economic capital on an internal basis. When these costs are multiplied by the thousands of banks within the global banking system, this will amount to billions of dollars in additional costs. Some of these costs will be passed on to consumers and corporations, and some of these costs may force banks to exit certain activities and leave those markets to unregulated entities.
    Procyclicality: the new rules will change how banks calculate their capital and the amount of business they choose to do. We have analyzed the impact of applying the Basel II rules to loan portfolios over the last 20 years of credit cycles. Our calculations indicate the new rules require much more bank capital during economic recessions when compared to the current system. As an example, let's think about the last few years. This period has seen a large number of corporate downgrades in a sluggish economy. Unlike the current accord, the proposed system will require significantly more capital in that environment. Under those circumstances, banks will have to choose between raising more capital or cutting the amount of lending they do.
    My personal estimate is that our bank would have cut back our lending by perhaps 20 percent if the Basel II rules were in place last year. If all banks cut back on lending at the same time, as they will tend to do under a common global regulatory regime, the potential adverse impact on the real economy could act to lengthen and deepen economic recession. While it is difficult to estimate the size of this effect, I would submit that herd behavior can make small problems into big ones.
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    In addition to credit risk reforms, Basel II also focuses on operational risk; the risk of breakdown in systems and people. While a more refined scientific approach to credit risk has considerable merit, the proposed quantification of operational risk is highly problematic, in my view. It would be great to quantify and control all risks with statistical methods, but there are fundamental reasons why this would be difficult to do with operational risk in practice. You have mentioned legal risks several times, and I think that is a particularly tough nut to crack.
    Can you really calculate the maximum loss a bank would suffer from that, or from potential fraud, an IT breakdown or a major disaster? How do you estimate how likely those events are? I have yet to see anything substantial that suggests that operational risk really is measurable in a way that is similar to market and credit risk. In fact, I think we may be creating a real danger, a false sense of security that we have measured operational risks and therefore controlled them.
    One of the strengths of the proposals is they go beyond capital calculations and also look to improve market transparency. While we support the concept behind the proposed rules here in Pillar 2I, the detailed proposals are cause for concern. We currently publish about 20 pages of detailed disclosure about risk in our annual report. We estimate that Pillar 2I would add another 20 to 30 pages of much more technical data to that total, but provide little of value to the reader. Indeed, few people in my experience are able to digest all of the information already presented on risk, and now this information would bury them in a deeper, more technical pile of data. While we support transparency, we believe the current proposals are more likely to confuse than to illuminate.
    In sum, we believe the Basel effort is a worthy goal, and we have a high regard for the efforts of the regulators who have worked very hard to build it. CSFB and the Financial Roundtable have also worked hard to contribute to that discussion in a constructive and open manner. Simplifying the complex rules currently found in Pillar I will require strong discipline in the next round of drafting, and return to some of the original philosophy of the project. I believe that much can be accomplished if we increase the emphasis on principles, rather than formulae in Pillar I, and if we increase the weight of Pillar II.
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    Pillars II and III have real people on the other side—regulators and the market. Real people can adapt to changes and new markets much more easily than a rule book can. This puts the burden back where it belongs, on the shoulders of bank management to demonstrate to the regulators, to you and to the public that we are doing a good job. That is in the spirit of the Sarbanes-Oxley reforms, and I think it is a smart and durable way to improve discipline.
    Thank you very much.

    [The prepared statement of D. Wilson Ervin can be found on page 58 in the appendix.]

    Chairwoman BIGGERT. Thank you very much, Mr. Ervin.
    Ms. Moore?


    Ms. MOORE. It is a pleasure, Madam Chair, to appear before the subcommittee to present our concerns on the revised Basel capital accord. I am Sarah Moore, executive vice president and chief operations officer of Colonial Banc Group, which owns Colonial Bank, a $16 billion bank operating in the southeast, Texas and Nevada.
    We anticipate the impact of the new accord will be far-reaching, as it will affect not just the largest banks, but rather its effects will be felt by banks of all sizes. Moreover, it will have a measurable effect on the nation's economy. The revised Basel capital accord is an extremely complex document. We believe Basel II has the unintended consequence of giving the largest U.S. banks an unwarranted competitive advantage over smaller institutions that compete against them, and importantly, places all U.S. banks at a competitive disadvantage to non-banks and to foreign banks.
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    We share the concerns about operations risk, but the most problematic issue in the accord for Colonial Bank and other regional banks is the proposed treatment of commercial real estate. We further believe that as drafted Basel II will lead to a loss of credit opportunities in the real estate sector since the accord treats lending to this area in an unreasonably disparate manner. Proponents of this new accord have argued that the accord will reduce the capital requirements for certain banks. However, with respect to real estate lending, no bank is able to utilize the tools under the accord for this purpose.
    While all other types of lending can utilize tools envisioned in the accord, real estate lending is set on a different shelf. Commercial real estate lending is identified in the accord as a more volatile high-risk type of lending than every other type of lending. banks that use risk assessment tools to measure performance of their real estate portfolios cannot, regardless of the performance of those portfolios, gain entitlement to lower capital standards, as the accord allows them to do with respect to every other type of lending.
    As a result of this arbitrary characterization of real estate lending and despite the hundreds of millions of dollars that will be spent in developing models and tools needed to comply with the accord, banks will be unable to adjust their capital levels to reflect the actual risk levels posed by real estate lending as determined by the tools themselves.
    Why did the Basel Committee use net charge-offs for all U.S. banks to develop risk-based capital allocations? I'll tell you. The numbers do not support the capital treatment provided under the new accord. This is made quite clear in the graph which we have attached to my written testimony. This graph illustrates net charge-offs by loan type for all commercial banks from 1985 through the third quarter of 2002. You can see from the data, since 1995, right in this area, that commercial real estate loans have had lower net charge-offs than consumer loans and C&I loans. Yet under the accord, banks must carry higher levels of capital for commercial real estate loans than all other types of loans.
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    Let's walk through an example of how a commercial real estate loan is treated in the proposed accord, versus an unsecured loan to WorldCom. Assuming we have a $100,000 loan collateralized by a fully-leased office building, the borrower has performed as agreed, with a good repayment history, this loan would carry a capital charge of $8,000. By contrast, a $100,000 unsecured loan to WorldCom, which had a Moody's credit rating of A2 prior to WorldCom's announcement of accounting irregularities, would have carried a capital charge of only $1,600. Which one do you perceive as higher risk: a loan collateralized by real estate, which you can touch and re-sell, or a promise to pay from a telecommunications company? While the accord is intended to strengthen banks, in this instance it encourages making unsecured loans, rather than secured ones.
    The proposed accord also would create an uneven playing field as a result of the lending patterns of the largest banks in the country compared to regional and community banks. The level of commercial real estate loans, as a percent of total loans, is twice as high for banks under $15 billion as it is for banks over $200 billion. In the southeast, non-mammoth banks carry an even greater load. Thus, an automatic and harsh treatment of commercial real estate disadvantages smaller institutions far more than larger ones.
    The inherent flaws in the accord would benefit only a handful of the largest U.S. banks, while the majority of community and regional banks would be burdened by higher capital requirements and increased expenses. Moreover, the disparate treatment of commercial real estate lending will manifest itself through significant credit crunches and dismal economic performance.
    With that in mind, we urge the Congress to require that prior to any action on an international agreement on capital standards, the federal banking agencies, in consultation with the Secretary of Treasury, evaluate the impact of such a proposed agreement, take into account a number of factors such as the impact of the proposal on small and medium-size financial institutions, the real estate markets, and other factors, and then submit a report to Congress.
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    I thank the subcommittee for allowing me to be heard today.

    [The prepared statement of Sarah Moore can be found on page 120 in the appendix.]

    Chairwoman BIGGERT. Thank you very much. I appreciate your testimony. Once again, we will have a round of questions at five minutes each, so please keep your questions short and your answers, and we will have more times for questions.
    I will recognize myself for five minutes. Ms. Petrou, which countries win and which countries lose as a result of Basel II? Are France and Germany and the United Kingdom going to be treated equally with the United States under the proposed new accord? You mentioned in your testimony that Germany threatened to leave the negotiations if they did not obtain favorable treatment for small and medium-size enterprises? How common are these tactics?
    Ms. PETROU. This is a negotiation. The rules will apply equally to all parties in the Basel accord; the United States, UK, Germany, France, Japan and so forth. The real question is once each home country's regulator opens the rulebook, how will they interpret it and how will they enforce it.
    Chairwoman BIGGERT. Thank you. Mr. Ervin, your bank seems to be in a unique position of having regulation by both the United States and Switzerland?
    Mr. ERVIN. As well as the UK and I believe approximately 100 other regulators around the world.
    Chairwoman BIGGERT. So you have many host countries to be under regulation. Do you think that there is going to be; how will that work?
    Mr. ERVIN. We are concerned. We have not seen how it will work yet. We already have tension, where occasionally one regulator will advise us to do one thing, and another regulator will request something different, and we need to comply with both. Sometimes that is very difficult in practice. That is a catch-22 situation. To date, that has been reasonably easy for us to manage, working cooperatively with regulators in the UK, Switzerland and here, which are our primary regulators. But the Basel accord is much more complex. It goes much deeper. I think you are going to have much more serious home-and-host problems going forward. The costs that we have talked about here will multiply very dramatically if we have to maintain multiple systems to satisfy the needs of multiple regulators.
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    Chairwoman BIGGERT. Do you see that with this new complex structure as potentially having an adverse impact then on global trade in financial services? Will this drive further divisions in an already sensitive area?
    Mr. ERVIN. I think you will see some significant changes in trade in financial services. I think this accord is enough of a ''big bang'' so that we do not know all of them yet. I am not smart enough to predict exactly which changes will happen. I do think there will be some incentives that potentially increase consolidation in some areas, some places where it will affect banks differently in different countries, and also some areas where institutions have to become non-banks to compete effectively. I think you will see a lot of changes in trade, I am just not sure what they will be exactly.
    Chairwoman BIGGERT. Thank you. Ms. Moore, what interaction has Colonial Banc Group had with the Federal Reserve and the other regulators during the negotiations surrounding Basel II? Has your input been solicited by the Fed?
    Ms. MOORE. It depends on which Fed you are talking with. The Federal Reserve Bank in Atlanta has solicited our comments, they met with us, they told us to get ready to begin to comply with the accord, which is contrary to what Vice Chairman Ferguson testified to this morning, that it will apply to only the 10 largest banks, and yet the Federal Reserve has told us that we need to get ready; that the expectation is that we should comply with the accord. We have had really no input into the process. I don't believe our voices were heard, it stopped at the Atlanta Fed.
    Chairwoman BIGGERT. I thought that as a regional bank that you would perhaps decide to be in it, or decide not to, but this sounds like it is more you might be told that you are in it.
    Ms. MOORE. The Federal Reserve told us that they expect us to begin compliance with the accord. We also believe that the market forces will dictate that we comply. We are a publicly traded company. We have 124 million shares of stock outstanding. We feel like the market will force us to compliance, or we will be viewed as unsophisticated. Of course, we are very concerned because of the competitive disadvantages that we believe this will create on a regional bank our size.
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    Chairwoman BIGGERT. If this were so, or even if you did decide, if that was changed, could you be prepared by January 1, 2007?
    Ms. MOORE. No.
    Chairwoman BIGGERT. Have any resources been directed to the effort?
    Ms. MOORE. A whole industry has developed around providing banks resources to help them comply with Basel. We have consultants calling us each and every day; we can help you; we can help you; buy this software; we will help. We do not have the internal resources. We are busy trying to run a $16 billion bank every day. I am the chief operations officer. We have a lot of technology projects that are trying to keep us competitive. This will divert resources away from things that will make us more profitable and make us a stronger financial institution, no doubt about it.
    Chairwoman BIGGERT. Do you have any idea what this could cost your institution to implement Basel II?
    Ms. MOORE. It will be tens of millions of dollars, not counting the internal man hours associated with Basel II.
    Chairwoman BIGGERT. Thank you very much.
    The gentlewoman from New York?
    Mrs. MALONEY OF NEW YORK. I defer to the ranking member.
    Mr. FRANK. I thank the gentlewoman, because I am going to have to leave after this.
    I would ask particularly the two bank representatives, Mr. Ervin and Mr. Spina, I remember asking Mr. Ferguson why publicity was enough, because he acknowledged that transparency would be the same in either case. His answer to me was, better they should go with Pillar I with their ability to impose a capital requirement, than to engage in Pillar II because in that case they may have to say rude things about you, and that would undermine the cooperative relationship. My question then is, from your standpoint, would you think it would be better to have Pillar I, which would have this I think somewhat rigid requirement, would you trade that for Pillar II with the possibility that that might lead them occasionally to make public comments about you? It seemed to me that he had it reversed in what I would want if I were involved, and I wondered if you would both address. Mr. Spina, why don't we start with you?
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    Mr. SPINA. I think that in one sense we would all want simple rules, but what we are dealing here in capital allocation and capital adequacy for a bank is complex. If you imagine a dialogue with a regulator and the Federal Reserve is our principal regulator at the bank level, because we are a state-chartered bank—if they have a Pillar I rule, then they start with the high ground, the authoritarian position. They have the weight of everything behind them, so we do not have any wiggle room. I am not saying that we should, in some cases.
    Pillar II, does allow for more dialogue Back and forth, but at the end of the day it is still the Federal Reserve, that is the decision-maker and they can still pull the rug on us and issue a cease and desist order or something like that. The question is whether they start the dialogue with all the authority behind them, or whether they finish it. I would much rather have it under Pillar II.
    Mr. FRANK. Mr. Ervin?
    Mr. ERVIN. I would agree with that. Like State Street, we pay attention when the Fed talks. That is regardless of whether it is Pillar I or Pillar II. Either one would be public. If your Pillar I calculations fall below a level, that is as public as if you were in a ''name-and-shame'' situation under Pillar II. Our point has mostly been that the mathematics and the modeling capability fits in Pillar I, and to my mind operational risk modeling really does not seem to be built on solid foundations.
    Mr. FRANK. I appreciate that. It did seem to me, as Mr. Ferguson explained, he said basically they wanted to stick with Pillar I rather than Pillar II because if they did it under Pillar II, they might reach the point where it almost sounded like it was Pillar I, so they start out with Pillar I. That is, they got to that point and I was not persuaded by that.
    Let me also ask, again this is new to us, but in some ways it seems to me the capital charge may be almost irrelevant to the evils they say they are trying to ward off; we have got ING, baring and some of the other, the Allied Irish Bank; would the level of capital charge we are talking about have been of any use, Ms. Petrou, in the situation of those, if there had been a capital charge, would that have helped greatly?
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    Mr. SPINA. I do not believe that it would have been sufficient to cover the losses in those cases.
    Mr. FRANK. Ms. Petrou?
    Ms. PETROU. No, I would certainly concur with that. I noted in Chairman Powell's testimony he talked about operational risk as the cause of many recent bank failures, and then he points out correctly that those operational risks were internal fraud, for example in Keystone. This committee had many hearings on the failure of Keystone National Bank, and you will recall that that internal fraud was in part inside chief executive officers burying piles of paper on assets they had said they had sold, they did not sell them, and they buried all the paper in their own backyard.
    I do not know what an operational risk-based capital charge would have done. To expect that on the one hand the risk managers would be calculating some form of measurement charge with the possibility upstairs, and then—
    Mr. FRANK. I appreciate that, but again there is obviously the analogy here to the capital that you need for lending risk, but it does seem to me with lending risk you are much more in a more or less situation that you may miscalculate. Whereas with this kind of risk, it seems to me more likely to be an either-or than a more-or-less, and it does seem to me that the capital charge and the level of a capital charge is more suited to the former. Is that a reasonable view, Mr. Ervin?
    Mr. ERVIN. I think that is a very reasonable view. It goes to the fundamental difference between the two. In market and credit risk, you take those risks specifically for the prospect of gain. It is part of your business. It's different with operational risk, nobody wants more fraud risk or more legal risk. You try and stamp that out as soon as you can find it. So that makes it a fundamentally different animal. I think that is one of the core reasons why it is hard to put under Pillar I.
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    Mr. FRANK. Yes, it does seem to me that more-or-less and either-or are different conceptual frameworks, and that we ought to do that. I assume we would agree that there ought to be very serious supervision here about management risk.
    Chairwoman BIGGERT. The gentleman's time has expired. The gentlewoman from New York?
    Mrs. MALONEY OF NEW YORK. Clearly, I think we need more hearings on this, and I am glad that the ranking member had called for this initial hearing, and I hope that he calls for more, because I think some very serious issues have been raised when three executives from American business and international business point out the flaws in this and the ways that they perceive it will really hurt their ability to provide services to our constituents, to consumers.
    I would really like Ms. Petrou to respond to the rather startling example that Ms. Moore gave, where the credit risk of buying WorldCom under the Basel accord, according to her example, would have been perceived a higher capital standard for the real estate than for WorldCom. Isn't the whole point of Basel to make the capital risk relationship more true to reality? The example she gave was exactly the reverse. So I would like to hear your comment on it.
    I feel that one of our roles in government is oversight. I am very concerned about any competitive disadvantage. If the bankers could just in your closing remarks go over what you think. We certainly do not in this country want to do anything that makes it harder for the American business, American financial banks to operate, because then that has a negative impact on people, on our consumers, on our constituents. I would like you to comment on the real life, real world consequences that this will have on your profitability, your products, and the impact on your constituents. But Ms. Petrou, could you please comment on the; I found her example startling—could you comment on that please?
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    Ms. PETROU. Yes, ma'am. It is. It is an example of the many problems I think that are buried in those thousand pages. When people sit down and start to run them, there are startling results. This is in part because the treatment of credit risk mitigation is still very incomplete. I would argue it is one of the things that Basel ought to be doing quickly; collateral, certain forms of loan insurance. There are numerous ways we have learned over the years to put somebody in the middle between a lender and loss. There is a lot that could be done to fix that, but I am not convinced the current version does.
    Mrs. MALONEY OF NEW YORK. I want to thank Mr. Oxley for calling for these hearings, and of course my colleague, Ms. Biggert, with whom we work on so many issues. Could you comment on the competitive disadvantage that all of you have testified, and also whether or not the Fed or the OCC has responded to your concerns when you have raised them.
    Mr. SPINA. From State Street's perspective, we compete in much of our products and services with non-banks. Accounting firms and data processing firms can offer similar services. We do offer bank-related services, which is why we keep our bank charter as well. But clearly, if we had a capital charge, that would impose a cost on the company. We would have to earn a return on that capital and our competitors would not be burdened with that cost. So I think it would be a material event in the sense that it would force us to reexamine our business model entirely and see how we provide those services.
    In terms of dialogue, we are uniquely focused in this kind of business, and we have benefited from a lot of dialogue and access to the Federal Reserve. I give them very high marks on that. The Boston Federal Reserve, the New York Federal Reserve and the Board of Governors have sponsored meetings both at State Street and in Washington and in New York. We have made our points, but we do not seem to come to closure, which is really why we are here. They hold their position that they think operational risk needs to be Pillar I, notwithstanding the arguments.
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    I have seen them bend in other related situations on different aspects of the credit risk proposal, after dialogue, and the proposals have gotten better, and this whole advanced management approach is a lot better than where we started a couple of years ago. However, we still cannot get them all the way to Pillar II, which is where we are focused.
    Chairwoman BIGGERT. I hate to break in here, but we have just a few minutes because of the timing of the room. So Mr. Ervin, if you could just in a couple of sentences, and Ms. Moore, we will have to complete our hearing.
    Mr. ERVIN. I would support Mr. Spina's comments. I think that some of the biggest differentials are going to be between banks and non-banks. We compete very heavily with non-banks in many of our lines of business. I am worried that we will become less competitive and potentially will have to cede some of those lines of business to non-banks going forward.
    With respect to national implementation, as I said before, we see a lot of differences in different countries. I would tell you that you do not need to worry about Switzerland. They are one of the toughest regulators out there. They are very proud of their banking tradition, and are very strict. But I think there is a risk that the stricter regimes, such as Switzerland or the U.S. regime or the UK regime, could be disadvantaged versus other countries.
    Ms. MOORE. I like the idea of more hearings. It is an excellent idea. I feel like the industry, especially banks of our size, are just now getting up to speed on the impact of Basel. When the regulators are telling you, and making public statements, that only Basel will apply to the top 10 banks; banks are thinking, great, I don't have to worry about that 600-page complex document, when in reality they should be worried about it. I believe these hearings will raise the awareness of the banking industry and get more people like Colonial Bank involved in the process. Thank you.
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    Chairwoman BIGGERT. Thank you. The chair notes that some members may have additional questions for this panel which they may wish to submit in writing. Without objection, the hearing record will remain open for 30 days for members to submit written questions to these witnesses and to place their responses in the record.
    Thank you all very much. You have been an excellent panel, and thank you for sitting and waiting through the other panel. We really appreciate it. I wish we had more time, but maybe you will be back. Thank you very much.
    The hearing is adjourned.
    [Whereupon, at 12:57 p.m., the subcommittee was adjourned.]