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Thursday, June 19, 2003
U.S. House of Representatives,
Subcommittee on Financial Institutions and
Consumer Credit
Committee on Financial Services,
Washington, D.C.

    The Subcommittee met, pursuant to call, at 10:06 a.m., in Room 2128, Rayburn House Office Building, Hon. Spencer Bachus [Chairman of the Subcommittee] presiding.

    Present: Representatives Bachus, Kelly, Toomey, Hart, Capito, Tiberi, Hensarling, Murphy, Brown-Waite, Oxley (ex officio), Sanders, Maloney, Watt, Sherman, Velazquez, Davis and Frank (ex officio).
    Chairman BACHUS. [Presiding.] Good morning. The Subcommittee on Financial Institutions and Consumer Credit is convened. The Subcommittee meets to examine the proposed Basel II Capital Accord and its potential effects on the domestic and international banking systems.
    The goal of Basel II is to develop a more flexible and forward-looking capital adequate framework that better reflects the risks facing banks and encourages them to make ongoing improvements to their risk assessment capabilities. The Subcommittee on Domestic and International Monetary Policy, Trade and Technology held a hearing in February to examine the proposal, where we heard from a distinguished panel of regulators, including Federal Reserve Vice Chairman Ferguson, Comptroller Hawke, Chairman Powell and a panel of private sector witnesses.
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    This hearing revealed that the federal regulators did not have a unified position on the scope and merits of Basel II. Following this hearing, I along with Congresswoman Maloney, Chairman Oxley, Ranking Member Frank, introduced H.R. 2043, the United States Financial Policy Committee for Fair Capital Standards Act.
    H.R. 2043 requires the federal banking regulators to develop a unified position on issues under consideration and the Basel Committee on Banking Supervision. Today, we will hear from the Federal Reserve, OCC and FDIC, along with OTS Director James Gilleran.
    Our second panel of private sector witnesses includes representatives of a large bank, a financial services trade association and university professor. I look forward to hearing from today's witnesses and thank them for taking time from their busy schedules to join us.
    I applaud the intent and the objectives of Basel II agreement: to ensure solvency of our banking institutions and protect against substantial losses; to create international standards to better manage risk; and align regulatory capital to economic risk.
    The distinguished witnesses on our first panel are to be commended for the work they have already accomplished on this agreement. Nonetheless, I have concerns regarding Basel II on several grounds.
    First, I believe it is unnecessarily complex and costly, with inflexible formulas replacing current rules and supervisory examinations. In addition, I believe that the current draft would create an uneven playing field, one that unfairly penalizes many banks in this country, particularly our regional banks.
    But my main concern is about the transparency of the Basel process as a whole and specifically, how the U.S. position at the Basel Committee is determined. I know that there has been an extensive comment period. And representatives of the Federal Reserve Board assure me that the banks that would be subject to Basel II approve of it.
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    Nonetheless, some of the banks have indicated to me, through their representatives, that they are in fact tremendously concerned about Basel. I understand that banks that have reservations about the U.S. position are hesitant to object openly to a regulatory agency that exercises power over them.
    This concern seems reasonable to me. I believe we must arrange for a full airing of the views of all interested parties, without institutional constraint.
    In addition, it has become clear to me that the bank regulators are not in agreement on the desirability of the accord as currently drafted. I am hesitant about this Congress supporting fundamental changes to our banking system in the face of a lack of consensus among thoughtful regulators.
    And I note at this time that the Senate testimony yesterday by banking representatives did describe Basel II as a fundamental change in banking supervision and regulation. H.R. 2043 would require the regulators to reach agreement by establishing a procedural framework for further deliberations on Basel.
    Our bill would create an interagency Committee, chaired by the Treasury Department, and include federal banking regulators. If the members cannot reach consensus on a position, the position of the Treasury would prevail.
    It is important that the secretary, as part of the elected administration, set U.S. policy. Yesterday, I announced at the Exchequer Club, that the Subcommittee plans to mark up this legislation in July.
    In closing, I want to thank Chairman Oxley, Ranking Member Frank and Mrs. Maloney for working with me to develop this legislation. I look forward to working with them and other members of this Subcommittee on this important issue. I also look forward to the testimony of our regulators this morning because, as I have said on two or three occasions, we are concerned that there are different opinions on Basel II and its effect on the banking institutions and our financial system as a whole.
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    I now am pleased to recognize Mrs. Maloney for an opening statement. Or Mr. Frank—I am sorry. Mr. Frank has come in.
    [The prepared statement of Hon. Spencer Bachus can be found on page 62 in the appendix.]
    Mrs. MALONEY. I defer to the ranking member of the Committee and appreciate so much his intelligent concern on this issue and so many others. Thank you, Barney.
    Chairman BACHUS. I just simply did not see that you had come in. So I apologize.
    Mr. FRANK. I try to be as unobtrusive as possible, Mr. Chairman.
    I appreciate your acknowledging that. I want to comment—and I appreciate your diligence in giving us a chance to be involved in this. I must say, I do get the feeling from the Federal Reserve that our interest is not entirely welcome. But that is one of the things that concerns me.
    I have procedural concerns here as much as substantive. And I was pleased to hear that you plan to move on this legislation because I think we have a very big problem in the way in which we formulate policy here.
    Globalization is a fact. It is probably as important in the financial markets, given the nature of money and its fungability in finance. Globalization is as powerful a force there as anywhere else.
    So formulating American policy to deal with these global issues is very important. And I think we do not have a coherent process in place for formulating these.
    And we began these conversations. And some financial institutions had substantive concerns, called them to my attention and the attention of some others.
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    We began these discussions based on those. But my concern broadened to include the procedures because we were initially told that there was a Committee of U.S. regulators that had come up with this common position.
    But it now is clear that two of the three federal agencies disagree with the position to some extent. And frankly, we were told, to some extent, by the Federal Reserve it seemed to me, that everybody was in agreement.
    And then we heard from the Comptroller of the Currency and the head of the FDIC that there was not agreement. And to adapt the line from Chico Marx when he was caught at something he had denied, the question became, ''Who are we going to believe, them or our own ears?''
    And I am going with my ears. And I think what we need to do is to create a structure here.
    I also continue to believe that while I, along with everybody else, have not just respect but gratitude for the great work that the New York Federal Reserve Bank does in helping us manage our financial institutions, it ought never to be considered to be on a par with those institutions of the federal government which have a Presidential appointee at the head who was confirmed by the Senate.
    So when we are told that there is a four-member Committee and it is the Federal Reserve Board, the New York Fed and the Comptroller of the Currency and the FDIC, I think that is not an appropriate structure. I should add that I have been concerned about some of the substance. And I will ask some questions specifically about that.
    But I also believe that, given the lack of coherence in the procedures and given the disagreements that evidently exist—and they are legitimate disagreements. These are not easy questions to answer.
    There is nothing wrong at all with there being legitimate differences of opinion among regulators. To some extent, they have different regulatory functions. But they also have inarturial perspectives. And these are the things that we ought to have discussed.
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    But given the obvious differences that continue to exist among the responsible regulators, it seems to me an error for us to go forward with what purports to be an American government position, which does not represent not just some of the important regulators, but frankly does not seem to have a lot of support in Congress.
    And as much as I respect the work that the Federal Reserve does, it is not, I think, empowered to speak for the U.S. government by itself to the extent that it seems to me to be doing in this situation. I do think that there needs to be some better working together.
    Now I would assume the Fed would have a major role here, a lead role in some ways. But I think that we have gotten ahead of ourselves in purporting to have a unified position from which there is significant dissent among the relevant regulators and within the Congress and the relevant Committees.
    So I appreciate this further chance to address that. And I thank you very much, Mr. Chairman, for your very diligent work in this regard.
    Chairman BACHUS. Thank you. Are there other members wishing to make—Chairman Oxley? Would you like to make an opening statement?
    Mr. OXLEY. Thank you, Mr. Chairman. And thank you for calling this hearing.
    I think the presence of the Chairman and the ranking member of the full Committee indicate how concerned we are about the whole process and that this rarely occurs. And I do think it does point out some concerns that we have, particularly because it does appear that the regulators have different opinions on this.
    Certainly, the last hearing reflected that. And subsequent events have also indicated a fissure within the regulating community here. And obviously, there are some concerns on this side of the dais as well.
    I am going to ask unanimous consent that my formal statement be made a part of the record, Mr. Chairman.
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    Chairman BACHUS. Without objection.
    Mr. OXLEY. But only to say that I echo some of the concerns that the gentleman from Massachusetts brought up in regard to the substance, as well as the process going forward. This is a big deal. And the decisions ultimately will reflect and affect the financial system in this country for a long, long time.
    And it is critical that we get it right, not just from the banking perspective, but a number of non-banking perspectives as well. I notice we have, on the second panel, some testimony from the Bond Market Association, which would indicate that there are some folks that have, perhaps, some opinions as well that are not technically in the banking community.
    So this has a broad reach and a long effect, a long-term effect on our markets and our banking system. And that is why I applaud the Chairman for his diligence in this.
    We thank him for scheduling a markup on the Oxley-Frank legislation. And I think it does reflect some of the very sincere concerns that many of us have.
    We have a great deal of respect for Mr. Ferguson and for the Fed and for their distinguished leadership. It does appear that there is a difference of opinion on this issue. And we need to make certain that, at the end of the day, we have a unified position from this side before going forward.
    And with that, I yield back the balance of my time.
    [The prepared statement of Hon. Michael G. Oxley can be found on page 60 in the appendix.]
    Chairman BACHUS. Thank you.
    Mrs. Maloney?
    Mrs. MALONEY. I thank the Chairman for holding this second hearing on the Basel II Capital Accord. For more than a year now, I have been closely following the progress of Basel II.
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    I participated in the earlier hearing. And I have met with regulators and bankers. After all this discussion, I still believe there are significant issues appropriate for congressional review. As early as last August 14, I wrote the regulators about this issue. And I believe that many of my concerns expressed then are still relevant. I remain concerned about the inclusion of operational risk in Pillar 1. And most importantly, I want to know more about what the ultimate impact of the accord will be on U.S. competitiveness.
    As a New Yorker, I am very aware of the contingency planning effort that financial institutions are taking for physical attacks. I want to be reassured that investments and business continuity planning, backup systems and insurance will not be reduced because institutions have to devote resources to capital charges for operational risk.
    From an international competitiveness standpoint, the U.S. is fortunate that we have the opportunity today to receive testimony from probably the most sophisticated and most professional group of financial service regulators in the world. In each country where Basel II is applied, the domestic regulators will ultimately be responsible for the compliance of the in-country institutions.
    Not every country has as distinguished a group of regulators as the U.S. And I fear that differing levels of application by various international regulators of such an enormously complex proposal could affect the competitiveness of our industry and have an impact on all of our constituents and our economy.
    For these reasons, I am pleased to have joined Chairman Bachus, Chairman Oxley and Ranking Member Frank in introducing H.R. 2043, the United States Financial Policy Committee for Fair Capital Standards Act. This legislation takes a balanced approach to ensuring a unified U.S. position at Basel and a full study of the effects of the accord on our domestic industry.
    I look forward to the markup in July. And I look forward to working with the Chairman on this proposal. And I thank him again for making it a priority of this Subcommittee.
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    And as I said, I am highly, highly concerned about the impact of Basel on the competitiveness of our financial institutions, our financial system. We should not do anything that would place the United States at a disadvantage by having a higher capital standard for U.S. institutions.
    I yield back.
    Chairman BACHUS. Gentleman from Pennsylvania is recognized.
    Mr. TOOMEY. Thank you, Mr. Chairman. I just want to briefly second the comments generally that the gentlelady from New York just made. One of my concerns is that we have the most robust, in some ways most aggressive and most effective regulatory framework for financial institutions arguably in the entire world.
    We also have some of the most competitive and most successful financial institutions in the world. And I am a little bit concerned about one specific aspect of the proposed capital requirements.
    And that would be that we would use a Pillar 1 approach for operational risk, which strikes me in many ways more appropriately dealt with under the Pillar 2 approach. And I am concerned that if we go with the Pillar 1 specific capital requirement, we would in fact be placing our financial institutions, extremely well regulated, extremely successful in a variety of ways, at a competitive disadvantage to other financial institutions.
    So I hope we get a chance to explore that issue at this hearing today. And I thank you for conducting this hearing, Mr. Chairman.
    Chairman BACHUS. Mr. Davis, do you have an opening statement? All right. Thank you.
    Ms. Kelly or Mr. Hensarling? All right.
    If there are no further opening statements, at this time I want to welcome our first panel of distinguished witnesses. From my left to right, they are: the Honorable Roger W. Ferguson, Jr., Vice Chairman, Board of Governors of the Federal Reserve System; the Honorable John D. Hawke, Jr., Comptroller, Office of Comptroller of the Currency; the Honorable Donald Powell, Chairman of the Federal Deposit Insurance Corporation; and the Honorable James E. Gilleran, Director, Office of Thrift Supervision.
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    I would like to commend you gentlemen on your work to date on the Basel Agreement, Basel II, and for the attention you have paid to this issue. I think there have already been positive changes in the U.S. position. We applaud those.
    I note from your testimony today, Vice Chairman, that you indicated further movement on the real estate issue, and I commend you for that.
    At this time, we will start with Vice Chairman Ferguson. We welcome your testimony. You will not be limited by the 5-minute rule. And I am sorry that some of you may not have received that message earlier. I apologize for that.


    Mr. FERGUSON. Chairman Bachus, members of the Subcommittee on Financial Institutions and Consumer Credit, Chairman Oxley, Ranking Member Frank, thank you for inviting me to testify on behalf of the Federal Reserve Board on Basel II and H.R. 2043.
    I will be brief. But I ask that my entire statement be included in the record.
    The development of Basel II over the past 5 years has been transparent and has been supported by a large number of public papers and documents on the concepts, framework and options, as well as by a large number of meetings with bankers. Over the past 18 months, I have chaired a series of meetings with bankers, often jointly with Comptroller Hawke.
    The banking agencies last month held three regional meetings with banks that would not, under the U.S. proposal, be required to adopt Basel II, but may have an interest in choosing to do so. The comment period for the third Basel consultative paper, sometimes called CP-3, is now in progress.
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    And in about a month, the banking agencies in this country hope to release an advance notice of proposed rulemaking, so-called ANPR, that will outline and seek comment on specific proposals for the application of Basel II in this country. We continue to be open-minded about new suggestions, backed by evidence and analysis, and approaches that simplify the proposal, but still attain its objectives.
    When the comments on CP-3 and ANPR have been received, the agencies will review them and meet to discuss whether change are required in the Basel II proposal. In November, we have scheduled to meet in Basel to negotiate our remaining differences.
    Realistically, this part of the schedule may be too tight because it may not provide U.S. negotiators with sufficient time to digest the comments on the ANPR and develop a national position to present to our negotiating partners. Some slippage in the schedule will no doubt occur.
    Implementation in this country of any final agreement on Basel II would require a notice of proposed rulemaking, an NPR, in this country in 2004 and, of course, a review of comments from that notice of proposed rulemaking. Additional quantitative impact studies starting in 2004, and probably conducted for the next 2 years, will also be necessary so we can be more certain of the impact of the proposed changes on individual banks and the banking system.
    As it stands now, by the fall of 2004, core and opt-in banks will be asked to develop an action plan leading up to final implementation. Whenever a final rule is developed, in 2004 or in 2005, there would be at least a 2-year lag before implementation.
    Within that implementation interval, the large banks to which Basel II will be applied in this country will be developing their individual bank implementation work plans in conjunction with their supervisor. As you know, most of the banks in this country will remain under the current capital rules. No bank that will be required or chooses to adopt the new capital accord would be forced into a regime for which it is not ready.
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    To be sure, supervisors will expect a formal plan with a reasonable implementation date from the latter banks once a final rule is developed. But no bank will be required to adopt Basel II if it has not yet built the required infrastructure.
    At any time during that period, we can slow down the schedule or revise the rules if there is a good reason to do so.
    Mr. Chairman, you have asked for the Board's views on H.R. 2043. We understand and support the bill's objective, to ensure that the people sitting at this table work together cooperatively and that all of us shape our positions, especially at Basel, with a full understanding of the likely effects of any decisions on our economy.
    With respect, however, the Board believes that the current process achieves those goals and that legislation is not necessary.
    Moreover, H.R. 2043 could be counterproductive. In the Board's view, the agencies have demonstrated their ability to work together, one must admit sometimes not as smoothly as perhaps others would like.
    But also, we have demonstrated our ability to change our minds on the basis of evidence and persuasion, as you have indicated, Mr. Chairman, in your opening remarks. The bill would reduce our ability to negotiate with our foreign counterparts, eliminate the room for us to disagree and work out our differences and involve Congress in technical supervisory and regulatory issues that are probably better left to the supervisors.
    Obviously, of course, we recognize the appropriate interest and role of Congress in aggressive oversight. And in that regard, I am obviously pleased to be here.
    Let me now turn to three other issues that have been raised about the current Basel II proposal. The first is competitive equity.
    While this concern takes several forms, the most frequently voiced is the view that competitive imbalances might result from what is called a bifurcated set of rules, requiring Basel II for large banks, while applying the current capital rules for all other U.S. banks.
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    The fear is that the banks that remain under the current capital rules, with capital charges that are not as risk sensitive, might be at a competitive disadvantage compared to Basel II banks that would get lower capital charges on less risky assets.
    We take this concern seriously and will be exploring it through the ANPR. But without prejudging the issue, there are reasons to believe that little, if any, competitive disadvantage would be brought to those banks remaining under the current capital regime.
    The basic question is the role of minimum regulatory capital requirements in the determination of the price and availability of credit. Our understanding of bank pricing is that it starts with the capital allocations that the banks themselves make internally, within their own organizations, then factors in explicit recognition of the riskiness of the credit and is then further adjusted on the basis of market conditions and local competition from bank and non-bank sources.
    In some markets, some banks will be relatively passive price takers. In either case, regulatory capital is mostly irrelevant in the pricing decision and therefore, unlikely to cause competitive disparities.
    Moreover, most banks—and especially the smaller ones—hold capital far in excess of regulatory minimums for various reasons. Thus, changes in their own or others' minimum regulatory capital, as might occur under Basel II, probably would not have much effect on the level of capital they choose to hold and would therefore not necessarily affect either internal capital allocations or the resulting pricing.
    Finally, the banks that most frequently express a fear of being disadvantaged by a bifurcated regulatory regime have for years faced capital arbitrage from larger rivals, who are able to reduce their capital charges by securitizing loans, for which the regulatory charge was too high relative to the market or economic capital charge.
    The advanced versions of Basel II to be adopted here would provide, in effect, risk-sensitive capital charges for lower-risk assets that are similar to what the larger banks have, for years, already obtained through capital arbitrage. In short, competitive realities between banks might not change in many markets in which minimum regulatory capital charges would become more explicitly risk sensitive.
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    Now I do not mean to dismiss competitive equity concerns. Indeed, I hope that the comments on the ANPR bring forth insights and analyses that respond directly to the issues, particularly the observations that I have just made.
    But to take a different view, we need to see reasoned analysis, and not just assertions.
    The second area of concern that I would like to focus on is the proposed Pillar 1 treatment of operational risk. Operational risk refers to losses from failures of systems, controls or people.
    Capital charges for such risks have been implicit under Basel I for the last 15 years. These risks will, for the first time, be explicitly subject to capital charges under the Basel II proposal. Operational disruptions have caused banks to suffer huge losses and, in some cases, failures—both here and abroad. My written testimony provides some recent and familiar examples.
    In an increasingly technologically-driven banking system, operational risks have become an even larger share of total risk. At some banks, they are indeed the dominant risk.
    To avoid addressing them would be imprudent and would leave a considerable gap in our regulatory system. The Advanced Measurement Approach—or the so-called AMA approach—which I am sure we will discuss further, for determining capital charges and operational risk, is a principles-based approach that would obligate banks to evaluate their own operational risks in a structured but flexible way.
    Importantly, a bank could reduce its operational risk charge by adopting procedures, systems and controls that reduce its risk or by shifting the risk to others through measures such as insurance. Some banks, for which operational risk is the dominant risk, oppose an explicit capital charge and would prefer the operational risk be handled case by case through the supervisory review of buffer capital under Pillar 2 of the Basel II proposal, rather than being subject to an explicit regulatory capital charge under Pillar 1.
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    The Federal Reserve believes that would be a mistake because it would greatly reduce the transparency of risk and capital that is such an important part of Basel II. It would lessen potential market discipline and would make it very difficult to treat risk comparably across banks because Pillar 2 is judgmentally based.
    The third concern I would like to discuss is the fear that the combination of credit and operational risk capital charges for those U.S. banks that are under Basel II would decline too much for prudent supervisory purposes. Speaking for the Federal Reserve Board, let me undermine that we could not support a final Basel II that caused capital to decline to unsafe and unsound levels at the largest banks.
    There will be several stages before final implementation, at which resulting capital levels can and will be evaluated. At any of those stages, if the evidence suggests that the capital were declining too much, the Federal Reserve would insist that Basel II be adjusted or recalibrated, regardless of the difficulties with bankers here and abroad, or with supervisors in other countries.
    But let us keep this in mind: supervisors can achieve their objective of maintaining the same level of average capital in the banking industry either by requiring that each bank maintain its Basel I capital levels or by recognizing that there will be some divergence levels of capital among banks because they will be dictated by different risk profiles of the banks.
    To go through the process of devising a more risk-sensitive capital framework, just to end with the Basel I result in each bank, is pointless. Greater dispersion in required capital ratios, if reflective of underlying risk, is an objective, not a problem to be overcome.
    Of course, one must also recognize that capital ratios are not the sole consideration. The improved risk measurement and management and its integration into the supervisory system under Basel II are also critical to ensuring the safety and soundness of the banking system.
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    Let me just say, by way of conclusion, that the Basel II framework is the product of an extensive, multi year dialogue with the banking industry, regarding evolving best practice risk management techniques in every significant area of banking activity. Accordingly, by aligning supervision and regulation with these techniques, it provides a great step forward in protecting our financial system and those of other nations to the benefit of our own citizens.
    We now face three choices. We can reject Basel II or we can delay Basel II as an indirect way of sidetracking it. Or we can continue the domestic and international process, using the public comment and implementation process to make whatever changes are necessary to make Basel II work effectively and efficiently.
    The first two options require staying on Basel I, which is not a viable option for our largest banks. The third option recognizes that an international capital framework is in our self interest, since our institutions are the major beneficiaries of a sound international financial system.
    The Fed strongly supports the third option.
    I will be happy to respond to questions. Thank you, Mr. Chairman.

    [The prepared statement of Hon. Roger W. Ferguson can be found on page 82 in the appendix.]

    Chairman BACHUS. I appreciate that.
    Comptroller Hawke?


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    Mr. HAWKE. Thank you, Chairman Bachus, members of the——
    Chairman BACHUS. Is the microphone on?
    Mr. HAWKE. It is the job of the Fed to help the OCC.
    Chairman BACHUS. That was the Vice Chairman that turned your microphone on.
    Mr. HAWKE. Again, I think it reflects on the fact that they have an unlimited budget and they can study things like this.
    Chairman Bachus, thank you, Chairman Oxley, Ranking Member Frank and members of the Subcommittee. We appreciate the opportunity to participate in this hearing. And I very much welcome the interest and involvement of the Subcommittee in these important issues.
    I want to assure the Subcommittee that the OCC, which has the sole statutory responsibility for promulgating capital regulations for national banks, will not endorse a final Basel II framework for U.S. banks until we have determined, through our domestic rulemaking process, that any changes to our capital regulations are practical, effective and in the best interests of the U.S. public and our banking system.
    In response to a point that Ranking Member Frank made in his introductory remarks about who is in charge here, I think it is important to recognize that Congress has clearly allocated to each of the federal banking agencies responsibility for overseeing the capital of banks within their jurisdiction and for adopting capital regulations. The Fed has authority over bank holding companies and state member banks; the FDIC over state non-member banks; and the OCC over national banks. So it is up to each of us, in the final analysis, to make our own decision. But the need for achieving agreement among the agencies, I think, is recognized by us all.
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    My written testimony provides a detailed discussion of the background and content of Basel II and the important issues with which this Subcommittee is properly concerned. I would like to use this time to make several important points that may help to put today's testimony into proper focus.
    First, all of the U.S. banking agencies share a concern about the potential effect of Basel II on the capital levels of large U.S. banks. Our banking system has performed remarkably well in the difficult economic conditions in recent years, and I believe that is due, in significant part, to the strong capital position our banks have maintained. While a more risk-sensitive system of capital calculation might be expected to have the effect of reducing the capital of some banks, we would not be comfortable if the consequence of Basel II were to bring about very large decreases in required minimum capital levels.
    By the same token, if Basel II were to threaten significant increases in the capital of some banks, it could undermine support for the proposal itself and might threaten the competitiveness of those banks. As things stand today, we simply do not have sufficiently reliable information on the effect of these proposals on individual institutions or on the banking industry as a whole.
    Before we can make a valid assessment of whether the results are appropriate and acceptable, we have to know, to a much greater degree of reliability than we now have, just what the results of Basel II will be.
    The OCC believes that significant additional quantitative impact analysis will be necessary. Even if the Basel Committee does not itself undertake such a study—and I think that would be the preferred approach—I believe it is absolutely essential that the U.S. agencies make such an assessment prior to the adoption of final implementing regulations. I strongly believe that we cannot responsibly adopt final rules implementing Basel II until we have not only determined with a high degree of reliability what the impact will be on the capital of our banks, but have made the judgment that that impact is acceptable and conducive to the maintenance of a safe and sound banking system in the United States.
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    Second, a number of Subcommittee members have commented on differences among the U.S. banking agencies and are of the view that a new interagency coordinating mechanism is needed. Mr. Chairman, you and some of your colleagues have introduced H.R. 2043, a bill that would establish an interagency Committee whose purpose would be to resolve such differences. While I am sympathetic to the concerns that underlie this legislation, with great respect, I suggest that it is not necessary at this time.
    There have, indeed, been some differences among the agencies during this process. But I believe the agencies have generally worked exceedingly well together on the Basel II project for the past 4 years, and I am confident that we will continue to do so. To be sure, we have not always agreed on every one of the multitude of complex issues that Basel II has presented, but that is no more than one would expect when a group of experts have brought their individual perspectives to bear on difficult and complex issues. Where there have been differences, we have worked our way through them in a highly professional and collaborative manner. In a few weeks, we will be jointly issuing an Advance Notice of Proposed Rulemaking, seeking broad comment on the Basel II structure, together with draft supervisory guidance for those of our banks that will be subject to Basel II. Both the ANPR and the guidance have been developed in a collaborative process in which each of the agencies has had substantial input.
    I believe we agree on the need for further quantitative impact study before Basel II is finally put in concrete although I do not want to speak for Governor Ferguson on that.
    I think it is probably correct to say that we at the OCC have had some reservations that the Fed does not share about the overall approach to Basel. For example, I commented in my earlier testimony about the complexity of Basel II. I have a concern about complexity because it seems to me that complexity could work toward competitive inequalities across countries, given the difference in the nature of supervision from country to country. Governor Ferguson, I think at the last hearing, pointed out that we live in a complex world and we are dealing with complex subjects, and complexity is a necessary consequence of this process.
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    We may have some difference of perspective on time schedule. I think the Fed wants—and I do not mean to speak for the Fed—but I think the Fed wants to adhere to the current time schedule. We certainly would like to, if it is possible. But I think we may have the view, more so than others, that achieving the present time schedule is a daunting challenge.
    While we had differed on operational risk at earlier stages of this process, I want to make clear that we are completely comfortable and supportive of the treatment of operational risk under the AMA approach in Pillar 1. And I would like to expand on that just for a moment because this is such an important issue for the Subcommittee.
    As the Subcommittee knows, I had argued earlier in the Basel Committee that operational risk should be treated under Pillar 2 because it involved qualitative judgments about the adequacy of internal control systems. Nobody else on the Committee agreed with that. And it was very clear to me that that view would not be accepted by the Committee.
    As a result, we and the Fed worked very closely together developing the Advanced Measurement Approach to operational risk. The product of that collaboration, I think, has been very productive. We are completely comfortable that the AMA approach to operational risk imports a degree of supervisory discretion and judgment of exactly the sort that would come to bear if this had been a Pillar 2 issue. Indeed, I think that if operational risk were to be treated under Pillar 2, it would be essential for us to have a framework for the consideration of operational risk that would probably look very much like what we presently have under the AMA approach. So I do not think the Pillar 1 versus Pillar 2 issue should any longer be a matter of significant concern.
    Third, as I said earlier, I think we are all committed to a process that has real integrity to it. The current Basel Committee timeline presents, as I said, a daunting challenge to both the U.S. banking agencies and the banking industry. And while it is clearly necessary to address the acknowledged deficiencies in the current Basel Capital Accord, the banking agencies must better understand the full range and scale of likely consequences before finalizing any proposal.
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    We have identified in our written testimony a lengthy and formidable list of critical milestones that the agencies must meet under the current Basel II timeline. They include: first, consideration by the Basel Committee itself of the comments that have been received on CP-3, its latest consultative paper. Next, the preparation and issuance by the U.S. agencies of the Advanced Notice of Proposed Rulemaking and draft supervisory guidance that goes with it, with a 90-day period for comments. At the end of that comment period, we will jointly consider those comments, analyze them, and make a judgment about the implications of those comments for the final iteration of the Basel document.
    The Basel Committee is presently scheduled to meet in December, which will give us the opportunity to feed back into the Committee the results of that ANPR process. We are also going to be requesting comment in the ANPR process on the economic impact of Basel II.
    Executive Order 12866 requires that we make an economic impact analysis in the case of any significant regulatory action, which is defined to mean an action that will have an annual effect on the economy of $100 million or more. We are soliciting information to enable us to determine whether that executive order will be triggered by the Basel proposal. If it is, we will conduct that economic analysis as part of this process.
    After the Basel Committee issues the definitive paper, the U.S. agencies will jointly draft and put out for additional public comment the final version of the regulations that will implement Basel II. At some point during that process—earlier rather than later, I hope—we will conduct an additional quantitative impact study to determine exactly what the capital impact will be.
    We will then consider all the comments that are received in the NPR process and come to a final decision as to whether we should issue the final U.S. implementing regulation and what it should look like. If we find that our current target implementation date of January 1, 2007 is simply not doable, consistent with that process—and my personal opinion is that realization of that target may be very difficult—we will take additional time. But I think it is still too early to draw that conclusion.
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    The important point here is that we will take great care not to let the timeframe shape the debate. If we determine that changes to the proposal are necessary, we will make those views known to the Basel Committee. And we will not implement the accord until those changes are made.
    I would like to make one more point. Some have viewed the new Basel II approach as leaving it up to the banks to determine their own minimum capital essentially, putting the fox in charge of the chicken coop. I do not think that is the case by any means.
    While the banks internal models and risk assessment systems will be the starting point for the calculation of capital, bank supervisors will be heavily involved at every stage of the process. We will publish extensive guidance and standards that the banks will have to observe. There will be standards set out in the Basel documents themselves. We will not only validate the models and systems that banks propose to use, but we will assure that they are being applied with integrity.
    In my view, the bank supervisory system that we have in the U.S. is unsurpassed anywhere in the world, in both its quality and in the intensity with which it is applied, and we are not going to allow Basel II to change that. In fact, if we do not believe, at the end of the day, that Basel II will enhance the quality and effectiveness of our supervision, we should have serious reservations about proceeding in this direction.
    Moreover, while Basel II has largely been designed by economists and mathematicians and while these ''quants'' will play an important role in our oversight of the implementation of Basel II, the role of our traditional bank examiners will continue to be of enormous importance. Such values as asset quality, credit culture, managerial competence and the adequacy of internal controls cannot be determined by mathematical models or formulas, nor can many of the risks that banks face be properly evaluated except by the application of seasoned and expert judgment. I can assure you that those national banks covered by Basel II will continue to be closely monitored and supervised by highly qualified and experienced national bank examiners who will continue to have a full-time, on-site presence.
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    I am pleased to have the opportunity to provide our views on this important initiative, I would be happy to answer any questions you may have.
    [The prepared statement of Hon. John D. Hawke can be found on page 141 in the appendix.]

    Chairman BACHUS. Thank you.
    Chairman Powell?


    Mr. POWELL. Thank you, Chairman Bachus and members of the Subcommittee for your interest in the new Basel Capital Accord. I believe that Basel II ranks among the most important pieces of proposed banking regulation in our nation's history.
    The FDIC supports the goal of lining up capital regulation with the economic substance of risk that banks take. Basel II encourages a disciplined approach to risk management and it addresses important weaknesses in our current capital rules. We applaud the intense and prolonged efforts that have been made to address these important issues.
    Since my testimony before the Subcommittee on Domestic and International Monetary Policy, Trade and Technology, on February 27, 2003, there has been good progress on the domestic implementation efforts. The federal banking and thrift regulatory agencies are working hard to issue an Advance Notice of Proposed Rulemaking for comment this summer. The proposed rulemaking will identify those aspects of Basel II that will be proposed for adoption in the U.S. for application to a small group of large banking organizations. At this time, we are addressing various technical issues, developing interagency guidance and conducting industry outreach.
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    Specifically, we have conducted outreach sessions to banking institutions of varying size at meetings held in Chicago, Atlanta and New York. We are approaching a crossroads where judgments will need to be made on some critical issues. The interagency process and the public comment period will help us reach those judgment, and I am confident that our process will result in an appropriate outcome. My written testimony provides a broad overview of some of the critical judgments that will need to be made before the agencies commit to adopt Basel II in the United States.
    The first key issue is capital adequacy. The Basel II formulas allow, at least in principal, for significant capital reductions. The proposals issued by the Basel Committee specify that after a phase-in period, there would be no floor on the level of risk-based capital that banks would be required to hold.
    The level of risk-based capital that banks actually hold would depend upon their own internal estimates of risk—validated by their supervisors—and on the demands of the marketplace. It is difficult to predict the ultimate effect of Basel II on overall bank capital, but we do know that the formulas are forceful tools for affecting risk-based capital requirements.
    There is no question the Basel formulas will help the regulators segregate risk. But the formulas cannot stand on their own.
    Banks face other risks besides credit risk and operational risk. Lending behavior can change over time, causing losses to escalate in activities perceived as low risk.
    The simple fact is that no one knows what the future holds. For these and other reasons, the FDIC believes that Basel II must be supplemented by the continued application of existing regulatory minimum leverage capital and prompt corrective action requirements. I am gratified at the support that my fellow bank regulators have expressed for this conclusion.
    We also understand that a leverage ratio alone cannot provide protection without the support of sound, risk-based capital rules. It will be necessary to better understand the impact of the proposals on the capital required for specific activities. Finally, maintaining capital adequacy under Basel II would be an ongoing task. Validating banks' internal risk estimates would be a challenge. Doing so consistently across agencies would be a greater challenge, for which an interagency process would be needed.
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    The other key issue is competitive equity. Basel II has been expected to provide some degree of regulatory capital relief. The banks that stand to be directly affected by Basel II have expressed strong support for such capital relief. They have expressed concern where they believe Basel II capital was too high.
    The key policy question is: what economic benefits and costs would come with changes in regulatory capital requirements? Would the economic benefit of lower risk-based capital requirements for large banks enhance their competitive posture or accelerate industry consolidation?
    We recognize there are differences of opinion about the importance of competitive equity issues, and that is why we need to pay close attention to the comments we receive on this issue. The agencies received a number of comments on both sides of this issue at recent industry outreach meetings, and this dialogue will continue.
    With respect to proposed House legislation, the FDIC appreciates the goal of H.R. 2043, ''The United States Financial Policy Committee for Fair Capital Standards Act.'' We share in Congress's desire to ensure that uniform U.S. positions are developed and communicated to the Basel Committee. However, we do not believe that H.R. 2043 is the best means to accomplish this end. The legislation would, in effect, move the important task of capital regulation away from the agencies with decades of experience in this arena to the United States Treasury Department.
    This could compromise the independence of the federal banking regulators and impair our ability to handle an important function of prudential regulation at a particularly sensitive time.
    As our testimony indicates, we are working with the other regulatory agencies to develop interagency positions regarding the domestic application of Basel II. The bank regulatory agencies are actively engaged in an almost daily dialogue on issues and concerns. We will take whatever time is necessary to seek input from all interested parties prior to the final adoption of the new framework in the U.S., especially the concerns of banks that may feel they will be disadvantaged in competing with Basel II banks.
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    In short, the ingredients for the success of Basel II continue to be: one, appropriate minimum capital standards; two, a consistent approach to validating banks' risk estimates; three, an adequate vetting of competitive issues; and four, time to address these and other policy issues as we finalize our views on this new Accord.
    We will continue to work closely with our fellow regulators to work through these important issues and reach the right conclusions. We are committed to evaluating the cost and benefits of the Basel II proposal and their impact on the U.S. banking industry and the safety-and-soundness of the financial system. Thank you for the opportunity to present the views of the FDIC.

    [The prepared statement of Hon. Donald Powell can be found on page 167 in the appendix.]

    Chairman BACHUS. All right.
    Thank you. Thank you.
    Mr. Gilleran, I am sorry.


    Mr. GILLERAN. Mr. Chairman, Ranking Member Frank, thank you for including me in this panel.
    Chairman BACHUS. I think we have a microphone problem.
    Mr. GILLERAN. I think all of the concerns that I have—the OTS has—have been already expressed. So I will just make some general comments before we turn it over to questions. I would ask that my written comments be included in the record.
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    Up until this time, the OTS has not been involved in the international accord efforts, even though we have had people who have been involved in Subcommittee work here in the United States. Bill McDonough did invite me to attend the last Basel meeting as an observer, which I did.
    And subsequently, I have asked the replacement for Mr. McDonough as head of the Basel Committee, who is now the head regulator in Spain, for an official seat on the Basel Committee. And I am told that that is a definite possibility for the future.
    I think it is important that the OTS be included as a full voting member on Basel because of the OTS unique focus on the mortgage industry. And our interest is, number one, to share with others our perspective on mortgage lending here in the United States and internationally, since at least one of our major thrifts will be included within the Basel Accord, if it is adopted.
    And we also have a focus on interest rate risk that is unique in the industry. And each quarter, we mark to market our entire industry, from an interest rate-risk point of view. So I think that that also is a contribution to the understanding of interest rate and the whole subject of risk and capital.
    My own personal views on Basel are that I believe that the Basel work to date has moved the ball forward in terms of understanding the relationship of risk and setting capital. Basel I was a simple method, but very effective really, since it was first adopted because Basel I capital has held up very well over very tumultuous economic times.
    And it has produced capital levels that are now viewed as being quite substantial. And in fact, the financial services industries have just completed 2 years of probably the best results it has ever had. And in addition, this year looks awfully good too.
    So Basel I has functioned well, even though I think that almost everybody would admit that if we just stayed with Basel I, we would want to make additions to it, so that it takes into consideration more of the kinds of differentiation of risks that we now have in the financial services industry. So I completely support the fact that we would have to do additional work on Basel I if that was the only thing that we had.
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    It has been expressed here that Basel II would only be applicable to 10 of the major international banks in the United States and perhaps 10 others who will opt in. I have received information from a number of people that there will be literally hundreds of other banks that will make application to the regulators to be able to use Basel II because I think it is perceived that Basel II will result in lower capital levels.
    And I think everybody—almost everybody—concludes that lower capital levels will mean greater competitiveness. It is also an issue too in connection with what happens to the community banks in the United States.
    Because if the major banks are allowed to have lower capital levels but the community banks will continue with higher capital levels under Basel I, then that will mean that they can be acquired, quite simply, by the major banks. And we will have a further roll-up of the community banking system here in the United States. And that has to be evaluated by Congress, along with everything else, as to whether or not that is a good thing to have happen.
    So I believe we have to do a lot of work. I believe a lot of work has been done.
    I salute those who have really been working on it so hard in the past. We intend to be part of it going forward in the future. And I believe that your attention to this matter is very well deserved.
    Thank you for inviting me. I look forward to questions.

    [The prepared statement of Hon. James E. Gilleran can be found on page 114 in the appendix.]

    Chairman BACHUS. Thank you. At this time, we will start questions.
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    And Vice Chairman Ferguson, my first question is, you have commented—let me read testimony from yesterday's hearing in the Senate. D. Wilson Ervin, Credit Suisse First Boston, are you aware of his testimony on Basel II?
    Mr. FERGUSON. I am generally aware of it. But it would certainly be helpful for you to read the quote that you want me to respond to.
    Chairman BACHUS. He said the proposed accord is not a minor refinement to the banking regulatory process, but is instead a wholesale reform of bank regulation, a regime that covers roughly $2 trillion of capital and is a key economic engine. Do you agree with that?
    Mr. FERGUSON. I believe that what the proposed accord is doing is to catch up with where the leading edge banks are. So yes, it is a change. It is a change from Basel I, without question.
    We have to move from Basel I because we believe it is no longer appropriate for our largest banks. It does not give good signals on the risks that they are undertaking. I do believe it is a major change, yes.
    It is, however, a change that is catching up with what the leading edge banks are doing. The ideas embedded in Basel II are not things that we, as regulators, thought up independently from the industry. It is a catching up to where the industry is.
    But yes, it is a major change.
    Chairman BACHUS. All right. What I guess I am having trouble seeing is—and you said that Basel II is an acknowledgment of what the largest banks are doing today.
    Mr. FERGUSON. What the leading edge largest banks are doing—not all of them, but what many of them are doing.
    Chairman BACHUS. Many of them. And your part of your testimony—is designed to have a regulatory capital system that reflects what the largest banks are doing today. And I think Senator Sarbanes asked you. And you saw it as just an acknowledgment about what they were doing today.
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    You mean what they need to be doing today or what they are doing today?
    Mr. FERGUSON. I am trying to use the word ''leading edge.'' Out of the many banks that we have, there are some—not all, some—that are using the kind of quantitatively-driven approaches to estimating their own internal capital, economic capital, getting a much better feel for the risks in their lending behavior, their credit behavior.
    Importantly, we had a discussion at the Federal Reserve Bank of New York about 10 days ago, almost 2 weeks ago now, where we saw again some leading edge banks are doing exactly the same kind of quantified approach to operational risk that is being proposed under the AMA. So both on the credit risk side and the operational risk side, there are examples of banks that are moving very much in this direction.
    There are some large banks that I think are further behind, some that are further ahead. So it is a validation, in a sense, that we reflect, and we encourage banks and give them incentives to continue to move in this direction. And we think it is quite doable because there are a number of banks that have already started to move in this direction.
    It still will require the, supervisory validation of the databases that they use, the approaches that they use to quantify. So as my colleague, Comptroller Hawke has indicated, there is still a great deal of room for supervisory oversight to guarantee that what comes out seems appropriate.
    And, it is important to recognize that the information that the banks provide is an input to formulas that the supervisors put forward. So that ultimately, it is the supervisors and the supervisory approaches and formulas that determine the capital.
    Chairman BACHUS. Let me ask you this. The same gentleman testified that the current Basel proposal is unnecessarily complex and costly. But you are actually saying that——
    Mr. FERGUSON. I am the first to admit that it is complex. I am not denying in any sense the complication here.
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    I think it is too simple to say that, in my view, it is complex because we live in a complex world. That is partially true. But that is——
    Chairman BACHUS. Can you tell me some banks that would comply with this today? You say that some of the leading edge banks already are?
    Mr. FERGUSON. Well, would comply with every component of it today? I am not sure there are any banks that would comply with every component.
    Chairman BACHUS. With the major components.
    Mr. FERGUSON. There are a number that are moving in this direction relatively quickly. I am a little cautious here to give out confidential information. But I will assure you that there are some banks that we have looked at. And we are comfortable that, certainly by the implementation date, they will be ready.
    Chairman BACHUS. But all your major banks today——
    Mr. FERGUSON. I am sorry, sir?
    Chairman BACHUS. All your major banks today are sound.
    Mr. FERGUSON. This is not a question of sound——
    Chairman BACHUS. I understand that. But their own models show that several of them are going to have to raise significant amounts of capital. Do you disagree with their models?
    Mr. FERGUSON. That they are going to have to raise capital? I think what will happen is that some will find that their regulatory minimum capital goes up. Some will find that the regulatory minimum——
    Chairman BACHUS. Right. Some go up, some go down. But for those that go up——
    Mr. FERGUSON. But that is not a bad sign. It means that their regulatory capital is going to reflect what many of them already recognize as what they need to hold internally.
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    I do not think there are any banks that are going to have to go out and raise new capital. They will simply have regulatory capital that is adjusted either up or down. But it is not inconsistent with their own view, necessarily, of their risk.
    Chairman BACHUS. Okay. All right. Let me ask you this. This is probably, maybe, the most important question I will ask you today.
    Comptroller Hawke and Chairman Powell said that we will take whatever time necessary to reach a consensus. Do you agree with that statement?
    Mr. FERGUSON. I do. As Comptroller Hawke was describing areas of agreement and disagreement, I sent him a little note and perhaps a little body language that suggest otherwise. But I think we are in close agreement on exactly that point.
    I have said in my opening statement here that the original timetable of trying to meet in November is unreasonable at this stage, and seems likely to slip. He described it as daunting. I would not have made it to this table if I were not prepared to take on a daunting challenge, so I am not intimidated by it.
    But I know we will have a lot of work to do. I am cautiously optimistic that we will get to the end of the year and have plenty of time to look at the comments, listen to the comments and respond to them, and develop a negotiating position.
    If it turns up that we cannot, then we will take the time required.
    Chairman BACHUS. Okay. So we do not have—there is no deadline out there. We cannot say we have to do it by a certain——
    Mr. FERGUSON. Let me be very clear. As with anything in life, there are cost and benefits. It is appropriate to get the benefit of taking a sufficient amount of time, sir. But it is also important for all of us to recognize that there are great costs of uncertainty to our banks.
    There are a number of banks that want to know where they should be investing, what kind of databases are required. So we have to move ahead as expeditiously as possible, in order to minimize the uncertainty in the banking industry.
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    This is not a matter to take lightly on either side. It is not a matter to rush into and ignore the comments, which we would not do. Nor is it a matter to go too slowly and leave uncertainty in the banking industry. Having seen 4 to 5 years of consultative papers, outreach meetings, quantitative impact studies, they are asking for a certain amount of certainty.
    And one of the things that you certainly will have seen, because you followed yesterday's testimony as well, while there are a range of views, when it is wrapped up, everyone recognizes that we need to move off of Basel I, both on the first panel and the second.
    I think Senator Sarbanes asked the question, in which the agreement was yes. Everyone recognizes that we need to move to a framework that is quite like Basel II, without question.
    There is still room to discuss a lot of the details. But the concept of moving in this direction is well accepted, both by the regulators and, I think, in general the private sector.
    And we have to be careful not to slow it down unnecessarily, slow it down enough to listen to the comments, but not unnecessarily to the point that we are leaving uncertainty in the banking industry and leaving our largest banks on an old accord that we know has passed its useful life, as far as the largest banks are concerned.
    Chairman BACHUS. Thank you.
    Ms. Maloney? Mr. Frank, I am sorry.
    Mr. FRANK. Thank you, Mr. Chairman. I know there has been frankly some effort to say that there really is agreement and you are all going to be able to work this out.
    But I would just make a suggestion to you. If this is an agreement, if you guys ever disagree, sell tickets, because it will be a hell of a show.
    Mr. Powell on June 9th said in a memo that we have, ''The framework is being rushed into place with discussions of significant alternatives now virtually ruled out by the timeline and by the international collaborative nature of the project.'' You do say, in a generous show of courtesy, you acknowledge the recognition by Vice Chairman Ferguson that this may, indeed, be the case.
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    You know, virtually anything may indeed be the case in this world. But then Mr. Ferguson expressed his view that this great rush to judgment may indeed be the case, in his answering memo, by saying, ''The Fed believes it is important to move on to the next step in an international process that has already created too much uncertainty.''
    I mean, there is clearly more disagreement here than people are acknowledging. And I do not understand what you think you gain by that. And I understand there are some constraints and let's be polite.
    But I have to say, Mr. Ferguson, you lose some credibility with me when you say, ''We are all together here.'' There seems to be much more disagreement.
    I do have a couple of specific questions.
    Mr. Hawke, you say that when you were for Pillar 2 instead of Pillar 1, you were the only member of the Committee who felt that, so you were outvoted. Mr. Powell, did you have a horse in that race between Pillar 1 and Pillar 2?
    Mr. POWELL. I did not.
    Mr. FRANK. You did not. So Mr. Hawke, you were outvoted one to one.
    Mr. POWELL. I am sorry?
    Mr. FRANK. Then Mr. Hawke was outvoted one to one. I mean, there were three federal agencies on this. You did not have a vote.
    Mr. POWELL. I came into the process late. But I would have to refer to some of our folks that were in the process. But I think we were in support of Pillar 2.
    Mr. FRANK. You were for Pillar 2? And Mr. Hawke, you were for Pillar 2. And Mr. Ferguson was for Pillar 1. So Pillar 2 lost one to two.
    Mr. HAWKE. Pillar 2 lost, Congressman Frank, in the Basel Committee. Pillar 2 lost by——
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    Mr. FRANK. Oh, not within the United States, but internationally, is that?
    Mr. HAWKE. Yes.
    Mr. FRANK. Okay, so the United States position——
    Mr. HAWKE. I made that argument in the Basel Committee.
    Mr. FRANK. I was not clear about that. The other question I would have for the gentleman from the OTS, you said you were asked to be made a voting member of the Basel Committee.
    Mr. GILLERAN. I was not a voting member, no. Not.
    Mr. FRANK. You said you had asked to be one.
    Mr. GILLERAN. Yes.
    Mr. FRANK. Well, who are the voting members of the Basel Committee. Are the other three? I mean, there is an international Basel Committee. You are all voting members. I am now unclear.
    Mr. GILLERAN. There are three U.S. members.
    Mr. FRANK. What?
    Mr. GILLERAN. One is the head of the New York Fed. And then there is a Washington——
    Mr. FRANK. Excuse me, are you asking to be a voting member of the International Basel Committee or the American Basel Committee?
    Mr. GILLERAN. I would like to be either. But I will take the U.S.
    Mr. FRANK. So you are asking to be a voting member of the U.S. Committee. But they do not seem to count the votes. I mean, that is like—I do not know why you want to vote.
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    Then I continue to be perplexed by this. And let me ask, Mr. Ferguson, both Mr. Powell and Mr. Hawke seem to have severe reservations about the current timeline. At least, that is—can you tell us that until they agree, their agencies agree that we are ready to go, that we are not going to go? Is that something we can——
    Mr. FERGUSON. I can tell you that. Yes.
    Mr. FRANK. Okay. Then let me ask you another question. And I understand, Mr. Powell, you make a point about getting Treasury into it. And that is something I will think about.
    But I still have to say, this is the most incoherent decision making process I have encountered on very important issues. And by the way, who will it be up to to make him a voting member?
    Do you know? You said you talked to the guy from Spain. I mean, is he deciding who is a voting member in America?
    Mr. GILLERAN. Right. Well, he is the Chairman of the Basel——
    Mr. FRANK. But does he decide who gets a vote in the United States?
    Mr. GILLERAN. He has a vote. And he is now Chairman. So he will determine when other countries and whether or not——
    Mr. FRANK. But what is his input into whether you get a vote in the United States Committee? I mean, I thought you said you were trying to get to be a voting member of the U.S. Committee. And we are going to ask a guy from Spain to do that?
    Mr. GILLERAN. Well, I did.
    Mr. FRANK. That is why I think we need some clarity.
    Now Mr. Ferguson, one substantive question. I understand one of your arguments has been—and I appreciate the willingness you have had to meet with us and talk and explain these things. I mean, it can be frustrating because these are complicated and we do not ever know as much about them as you do because of the difference in our focus of attention—and maybe even our attention span, but I will speak only personally there.
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    On the question, you have said, well, the amount of capital may not be that much. It would not be necessarily increased. But there is a big gain in transparency.
    And you and I have had this conversation, that you said that you thought some of the institutions, while they might now have capital, have not been transparent about it. I relayed that concern to some of the institutions that had raised this with me.
    And I am told that one of them, State Street Bank, said that they would be willing to work on ways to increase the transparency of the capital. And that did not seem to resonate much.
    So are there not ways or are there ways that we could require these institutions—talking about operational risk now—to increase the transparency of the capital that might be helpful here? And I was frankly—I encouraged them to go and talk to you about that. And the impression I got was that they did not think this really meant as much to you as I had thought it did.
    Mr. FERGUSON. Transparency always means a great deal to me. And there should not be any doubt about it.
    And yes, the institution that you talked to called me the other day to say they would be interested in pursuing ways to have more transparency. Recognize the benefits of Pillar 1, which is what we are talking about, versus Pillar 2 are in part because of transparency, not exclusively.
    Mr. FRANK. Right.
    Mr. FERGUSON. I am sorry, Congressman Frank, may I finish?
    Mr. FRANK. I am sorry. I thought you were finished.
    Mr. FERGUSON. No, not yet.
    Mr. FRANK. My attention span again. I apologize.
    Mr. FERGUSON. There are a number of other benefits from Pillar 1 that are important. One is that it allows for greater comparability because it is important to have framework——
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    Mr. FRANK. Okay. In other words, what you are saying is that even if they could resolve the transparency issue, that would not affect your view on——
    Mr. FERGUSON. No, I did not say it did not have any effect on my view. What I said, Congressman, is not that it would not have an effect on my view. Obviously, it would have an effect on my view.
    I think it is not the only reason to favor Pillar 1.
    Mr. FRANK. Okay.
    Mr. FERGUSON. And as you have heard now at this stage, the regulatory group in front of you——
    Mr. FRANK. By a vote of one to two.
    Mr. FERGUSON. No, Congressman Frank, that is unfair.
    Mr. FRANK. How did the American—what was——
    Mr. FERGUSON. It is unfair because, as I think you heard the Comptroller say, we collectively developed what we think of as a very solid middle ground.
    Mr. FRANK. After he felt he had been outvoted, he said that.
    Mr. FERGUSON. He had been outvoted by the entire Committee.
    Mr. FRANK. But let me—if the Comptroller thinks I am misquoting him, he is free to interrupt me. I give him that permission.
    The last question I have is this. You say one of the reasons for speed or for moving quickly, despite others' reservations, is——
    Mr. FERGUSON. Can I interrupt you? I did not say ''moving quickly.'' I said ''reasons to move ahead.''
    Mr. FRANK. Okay. But you said one of the problems was the uncertainty that the financial institutions are suffering from. I just want to give you a comment.
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    Not a single bank has called me up and said, ''Hey, I am really feeling angst here from the uncertainty. Would you move quickly?''
    So you say that it is important to move quickly because you want to relieve the uncertainty of the banks. But they are calmer than you think they are.
    Mr. FERGUSON. It is a good thing we have calm regulators and calm banks. I did not say ''move quickly.'' I said to ''continue to move.''
    Mr. FRANK. I understand. But you said a reason for progress and not as much delay.
    Mr. FERGUSON. Right.
    Mr. FRANK. Are you not in disagreement with your colleagues about how much delay?
    Mr. FERGUSON. No, I am not in disagreement with my colleagues at all.
    Mr. FRANK. Dr. Ferguson, I have to say I do not believe that. I mean, you are not leveling with us. There is clearly a difference of opinion on how quickly this ought to go.
    Mr. FERGUSON. No, Congressman Frank, there is not a disagreement on how quickly this should go. We all agree that we have to put out an ANPR in about——
    Mr. FRANK. Okay, well then——
    Mr. FERGUSON. We all agree that we need to have a comment period. We all agree——
    Mr. FRANK. Report to——
    Mr. FERGUSON. Sir, may I finish?
    Chairman BACHUS. Let me say this, we have actually got 2 minutes left on the floor.
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    Mr. FRANK. All right. I apologize.
    Mr. FERGUSON. No, I think it is fair to ask questions. But I am giving you honest answers. I am not, in any sense, disagreeing with what anyone else here——
    Mr. FRANK. That is not what these two memos clearly suggest.
    Chairman BACHUS. Could I interject? Vice Chairman, could you—would you write Chairman Oxley and Chairman Frank a letter and just confirm what you have said this morning?
    Mr. FERGUSON. That we will have a comment period?
    Chairman BACHUS. That you will not——
    Mr. FERGUSON. Of course.
    Chairman BACHUS. That you will not move forward until——
    Mr. FRANK. Mr. Chairman, I will return to listen, not to ask any questions. But I owe them. I will return after I vote to listen.
    Chairman BACHUS. We will return. And we ask the panel—we will reconvene at a quarter till 12. Thank you.
    Chairman BACHUS. The hearing will come to order. We welcome our four witnesses back. And at this time, two of the witnesses wanted to respond to Mr. Frank. So I will recognize the ranking member for that purpose.
    Mr. FRANK. I simply—both Dr. Ferguson and Mr. Gilleran had comments to make. And I, having used up my time, I hope they will get as much time as they need to respond.
    Mr. GILLERAN. I just wanted to clarify the record is that the OTS is fully engaged with the other regulators here going forward in the United States. And we are a party to the ANPR that will be coming out.
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    And it is the international piece in Basel that I was talking about, that we have not been—had a seat at the table. I have been informed by Comptroller Hawke that Basel has never really ever taken a vote.
    So you cannot be a voting member. But we would like to be at the table going forward, so that we can add our unique perspective on the mortgage market to the group.
    Mr. FRANK. Dr. Ferguson may have felt that I did not give him a chance. So I apologize.
    Mr. FERGUSON. I have the impression that some of my colleagues here want to deal with some of your questions.
    Mr. POWELL. May I make a comment, Congressman? With regard to the different views and differences of opinions, clearly that is true.
    In my short period in Washington, I have watched; there is not much consensus on very many issues. And time builds consensus. People have an opportunity to express their views.
    I indeed did send that memorandum to Vice Chairman Ferguson and to Comptroller Hawke and expressed our views. And I have met with Vice Chairman Ferguson at least on two different occasions, going over some of my concerns and some of my views.
    He has accepted those concerns and views in the spirit they were given. On one occasion, he called me back and said that he is doing some more study about one of the specific issues that I talked about.
    I am confident—I am confident—in the process. As Comptroller Hawke mentioned, people of good will, in fact, have differences of opinion. And I think it is important that we express our differences of opinion.
    But I am confident that the process will ultimately get us to a consensus. There will be give and take in this process, and as each of the panel members here have expressed, we will not be governed by the timeline just in order to make a certain timeline. Governor Ferguson, Comptroller Hawke, Director Gilleran, and I do have differences of opinion. But we have worked through other issues. And I am confident we will work through these issues.
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    Mr. FRANK. Let me just—you do not then feel pressured by any timeline? You feel you have adequate time to work it out?
    Mr. POWELL. No, sir. I do not feel pressure in any way.
    Mr. FRANK. And you will not feel pressured to give in before you are satisfied?
    Mr. POWELL. Nor do I feel pressure to change my views, nor feel any pressure not to express my views.
    Mr. FRANK. I have never noticed a deficiency in your willingness to deal in those regards.
    Mr. POWELL. Thank you.
    Chairman BACHUS. Let me clarify something. Right before we left, Vice Chairman, I asked you—in fact, Chairman Powell's statement just then sort of reminded me that he is confident. And Comptroller Hawke has said he is confident that you all will come to a consensus at some point.
    And you assured us that—I believe I have heard that you have assured us that you will not sign off until there is consensus and agreement between the regulators?
    Mr. FERGUSON. That is correct.
    Chairman BACHUS. Now in that regard, we are talking about the same thing, and that is the international Basel agreement?
    Mr. FERGUSON. Yes, that is correct.
    Chairman BACHUS. Okay. Thank you.
    So you will not sign the international agreement until there is.     Mr. FERGUSON. I cannot. I mean, you have to understand that the Fed is only one of the regulators here. We cannot, independently of the other regulators, move forward. We need to have exactly what you want us to have, which is a common view before we go ahead.
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    Chairman BACHUS. But there is a U.S. agreement on how you regulate between the regulators. There is also the international agreement which you sign.
    And what I am focusing on is that you will not sign.
    Mr. FERGUSON. First, there is nothing to sign. But we will not agree to anything that we are not all appropriately comfortable with.
    Chairman BACHUS. Okay.
    Comptroller Hawke?
    Mr. FERGUSON. Are you comfortable with that, sir?
    Chairman BACHUS. Yes.
    Mr. HAWKE. Mr. Chairman, let me go back to the timeline of the process itself. The comment period on our ANPR closes in October. There is a meeting of the Basel Committee scheduled in December. We will take a broad range of comments that come out of that ANPR process and make an initial judgment about whether and to what extent we think changes should be made in the final document that is going to come before the Committee in December. The Committee will then put that out as the final document. The Committee, in the 4.5 years that I have been on it, has never taken a vote on anything. Things seem to get done by osmosis.
    That document will be the Committee's view on the final paper. We are not obligated to apply it to U.S. banks until we complete our domestic rulemaking process that implements Basel II through our rules.
    The final step in that rulemaking process will be the Notice of Proposed Rulemaking, which will come after the issuance of the Basel paper. That is when we are going to do the final quantitative impact study that will measure the impact on capital of the Basel paper. If that quantitative impact study returns information to us that suggests that the impact on U.S. bank capital is going to be unacceptable, as the Vice Chairman said, there are a number of things that we can insist on with the Basel Committee before we go final with our implementing regulations.
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    So there are a number of decision points along the way before we get to the very end of the line, which is the adoption of the U.S. regulations implementing Basel II.
    Mr. FRANK. Mr. Chairman, would you yield to me for 30 seconds for a question? Because that is interesting to me. And I must say, my impression before the Comptroller spoke was that once the agreement was signed, our flexibility was not very great.
    I mean, how much could you undo? Are you not bound by—are you talking about details? Or could you say, ''Well, we do not want operational risk capital'' or ''We do not want this?''
    Subsequent to signing, when we do our regulation, how much are we constrained by international obligation? How free are we?
    Mr. HAWKE. Well, first of all, this is not a treaty where we have a legal obligation. But I think it is probably fair to say that once the Basel Committee goes out with its final paper, we either should object to it if we have fundamental reservations, or we should acquiesce in its being published. But during the subsequent domestic rulemaking proceeding and the quantitative impact study that will accompany that, we are going to have to make a very important judgment, and that is: what is the impact of this paper going to be on the capital of our banks? We have not had a reliable——
    Mr. FRANK. How free will you feel to undo parts of what you agreed to?
    Mr. HAWKE. Well, I would feel free if we conclude as a result of the quantitative impact study that the capital impact on our banks would be unacceptable—unacceptably high or unacceptably low to simply not implement it.
    Chairman BACHUS. And that would mean, even if it resulted in some competitive disadvantages for certain banks over other banks or if it impacted specialty banks or if it impacted banks with high commercial real estate holdings.
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    Mr. HAWKE. Those are issues, Mr. Chairman, that I think we ought to have a better hold on at the end of the ANPR process. We are going to be receiving comment on the competitive impact before the end of this year. So we ought to be informed on those issues before we go back to the Basel Committee in December.
    Mr. FRANK. Can we hear from Dr. Ferguson on that, Mr. Chairman?
    Mr. FERGUSON. Let me first agree with the direction that Comptroller Hawke was going in response to your question, Congressman Frank. We should have a strong sense of agreement about the broad contours before the Committee wraps up its work, without question.
    I agree with him that the proposal or the approach for next year will be to put out a notice of proposed rulemaking; to start a quantitative impact study; to get the comments from that notice of proposed rulemaking; to get the input from the quantitative impact study; to collectively make a judgment as to whether or not there is a need to go back and reopen; to do what we call recalibration, which is to adjust some of the weights in one way or the other, to make other adjustments that we think are appropriate before we sign on.
    And as the Comptroller has indicated, this is not self-executing. It needs some rules here in the U.S. And before we finalize those rules, I think it is important to do the process.
    Mr. FRANK. But you are assuming——
    Mr. FERGUSON. And, if we need to, go back and renegotiate. And we have said that. This is not the first time we have said that.
    Mr. FRANK. When you talk about the timetable, you are assuming that this would be done by the end of this year, the international agreement.
    Mr. FERGUSON. As the Comptroller says, it is a daunting task. We have to work hard to see if we can get there. We will go to the December meeting with our collective reflections on the comments and lay out to our negotiating partners what the U.S. positions are. And we will see how far we can get.
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    The expectation, the commitment the Committee has made to the world, is that we will attempt to get some finality the end of this year. I want to try to live up to that if we can.
    If it turns out that we cannot reach a consensus on the Committee, then so be it.
    Let me add one other point on this. If I can take another minute to give the Committee a really clear view, because I see this is an issue of some uncertainty.
    Not only is 2004 a chance where we will have a quantitative impact study. But as I said in my opening statement, there will be—I think—a quantitative impact study in 2005. There will probably be one in 2006.
    At each one of those, we will get a better handle on the impact on our banks and the banking system overall. And frankly, I believe that if we have to go back and reopen and recalibrate to some degree, we have the right to do that. We have been clear that we intend to do it.
    Chairman BACHUS. When you say you think that we have that right.
    Mr. FERGUSON. No, we intend to do it. We have the right.
    Chairman BACHUS. We do have the right?
    Mr. FERGUSON. We have the right to do it. We will, if we do not like and are uncomfortable with the quantitative impact on the banks in the U.S., go back and recalibrate. Period. Full stop. Declarative sentence. I hope it is clear.
    Mr. HAWKE. Mr. Chairman, can I just add one point on that?
    Chairman BACHUS. Yes.
    Mr. HAWKE. Up until now, the Committee itself has done three quantitative impact studies, but they have not had a final document to work against. So it has not been possible to calculate the impact of Basel II on our banks because we were dealing with a work in progress. It will not really be possible to calculate the impact until our banks get all their systems up and running and we have a fully operational system. But after the Committee comes out with the final version of the paper, we will be in a much better position to go through a quantitative impact study, that will be carefully overseen by the regulators, to make a judgment about what the impact will be. That is an absolutely essential step, in my view, and satisfactory results will be a precondition to our final adoption of the implementing regulation.
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    Chairman BACHUS. Thank you. And let me say this, what I am going to do at this time, Mr. Toomey, the gentleman from Pennsylvania, is going to take the chair and recognize Mr. Gilleran. He has been wanting to respond.
    What we are doing, as you have noticed, is we are going to give each member remaining here 10 minutes of questioning because these are very important matters. And I think, Mr. Frank, I would agree, we have taken close to 10 minutes.
    Mr. FRANK. Is 12 close to 10?
    Chairman BACHUS. So what we will do is Mr. Toomey will take the chair. He will have his 10 minutes to question. Then we will go to Ms. Maloney and the other two members that are here.
    And the other members that arrive after that will have 5 minutes.
    Mr. TOOMEY. [Presiding.] Thank you, Mr. Chairman. At this time, I would recognize Mr. Gilleran to respond.
    Mr. GILLERAN. I just want to say that Basel II is no different than Basel I as far as it relates to the authority of the U.S. supervisors to request capital and to obtain capital that they think is necessary. If Basel I came up with the calculation that the regulators disagreed with, the regulators are not bound by Basel I, in terms of the capital that is required.
    And they would not be bound by Basel II in any different way. And I think it is very important to point that out, that Basel II is a technique to get to a number. But it does not bind the regulators as to what is required in any specific instance.
    Mr. TOOMEY. Thank you. I would like to begin my questions following up on the question of the question of the impact on the competitiveness of American banks if we were to proceed with the Basel II proposals. And specifically, it is my understanding that the majority of the institutions that engage in the asset management operations, for instance, do not come under Basel requirements at all. It does not apply to them.
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    And in addition, it is my understanding that the actual capital required by the market for the conduct of this business is considerably less than what the Pillar 1 requirement under Basel II would impose. So I guess my first question for either Mr. Ferguson and/or Mr. Hawke would be, number one, does this discrepancy between what the market requires and what the Basel proposal proposes, does that suggest a flaw in the requirements?
    And secondly, if we were to adopt this Pillar 1 requirement, wouldn't that put our American institutions at a significant competitive disadvantage and have all the unintended consequences that flow from that, including creating incentives to push this business elsewhere to avoid this capital requirement?
    Mr. FERGUSON. Was that question addressed to me, sir?
    Mr. TOOMEY. Actually, if you and Mr. Hawke would both address the question, I would appreciate that.
    Mr. FERGUSON. Okay. Well, I hope we get the same answer.
    First, we will be asking questions about the competitive impact broadly. And it will include, by implication, the kinds of issues that you have just raised. So we will get the facts, as far as the industry sees them.
    Secondly, I would say, recognize that there are already bank and non-bank participants in the asset management activity. As far as I can tell, the capital requirements are probably slightly different because the market has slightly different requirements versus what the banks have to hold.
    There are reasons that we have capital requirements for banks, obviously, because they are regulated institutions. They have access to a variety of things that deal with the safety net. And so as we think about the competitive differences, we have to calibrate it against what currently exists, as opposed to an ideal world.
    To try to respond to a technical question, just to make sure you understand what the accord calls for, it calls for capital with respect to the credit elements of the asset management activity. Insofar as a bank that is an asset manager makes a loan as part of that activity, that would require capital.
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    General asset management as an activity does not, I believe, attract capital. And the way that gets calculated will depend very much on the inputs, the probability of default, et cetera, that are involved.
    Mr. TOOMEY. I may have misspoke. I was referring to the operational activities generally.
    Mr. FERGUSON. Oh, operational activities generally. Oh, I am sorry. So your issue then is about operational risk.
    Mr. TOOMEY. That is right.
    Mr. FERGUSON. Oh. I thought you said asset management.
    Mr. TOOMEY. I am sorry. I did, I think.
    Mr. FERGUSON. Let me then, since you and I know Congresswoman Maloney is also interested in this issue, I will also continue a bit on operational risk.
    The first point to make is operational risk already attracts an implicit capital charge. We are not doing something new by having capital for operational risk.
    Excluding or even leaving what the regulators call for, large financial institutions, large banks in particular, already hold economic capital, the capital they themselves determine, in order to deal with the challenge of operational failures. We have done a survey that shows in the world at large, for larger institutions, out of their economic capital, the capital they impose upon themselves, about 14 to 15 percent of that capital is being held for operational risk matters.
    So just to get the lay of the land, there is already regulatory capital for operational risk, regulatory minimum capital and the banks themselves impose their own economic capital.
    Mr. TOOMEY. But that is a significantly lower number than what is contemplated by Pillar 1?
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    Mr. FERGUSON. No, that is not true. No, that is not true.
    Mr. TOOMEY. Oh, it is not.
    Mr. FERGUSON. I think there may be a little bit of a misunderstanding. There was a time, several drafts ago, when operational risk charges were either tied to gross revenue or you may be thinking of a number of 20 percent that was floated at one point.
    That is not the proposal. The proposal under the Advanced Measurement Approach, the AMA approach, as I have described it and as Comptroller Hawke, who was part of developing this idea described a bit, is a principles-based approach that does not have implicit in it a specific target number of capital.
    Rather, it asks the banks to use some quantification that we as regulators can replicate, that we can understand, that is not purely top-down, judgmental, a guess, if you will. But based on an analysis of their own experience, the experience of others, what is called scenario analysis and a few other techniques that are relatively common in this area, to determine their perception of the operational risks they might face.
    Mr. TOOMEY. Okay.
    Mr. FERGUSON. And then how they offset it. And that will lead to a capital charge. But it will not necessarily be higher. We do not know if it is going to be higher or lower than the 15 percent that—or 14 to 15 percent—of economic capital that is currently held, that I have just alluded to.
    Mr. TOOMEY. Okay.
    Mr. FERGUSON. I hope that is clear.
    Mr. TOOMEY. Yeah, it is surprising. I was under the impression that it is extremely likely that it would be considerably higher than the economic capital that the market requires today. But that is——
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    Mr. FERGUSON. I do not think we can have a point of view that it is extremely likely to be one thing or another until the banks work their way through it. A number of banks have already developed some of these approaches and are moving along, which gives me some comfort that what we are proposing, what is being proposed with this AMA approach, is really quite doable.
    But it is, I think, premature to say it is extremely likely to lead to a particular number in the industry.
    Mr. TOOMEY. Okay.
    Mr. Hawke, is that your view as well?
    Mr. HAWKE. I generally agree with Governor Ferguson. I would just make a couple of points.
    We already have differences today between regulated financial institutions that carry on such things as asset management activities and non-regulated institutions that carry on the same activities. There are pluses and minuses in each case. The regulated institutions have access to the discount window. They have the benefit of the federal safety net and the like. The non-regulated institutions do not have the burden or regulatorily imposed minimum capital requirements.
    We are going to be seeking comment on the competitive effects in the Advanced Notice of Proposed Rulemaking proceeding. We would be concerned if one of the consequences of Basel II were to cause the de-banking of banks that were engaged in these activities. So this is an issue that we are going to focus on in this process.
    Mr. TOOMEY. Okay. So do you share the view that it is not possible to determine, generally speaking, that these rules would require greater capital than the market currently imposes?
    Mr. HAWKE. I think it is premature to make that judgment. The AMA approach has a lot of complexities to it. We have very extensive supervisory guidance that is about to be put out for comment that details this whole process. Until that guidance is finalized and we get a final Basel paper, I think it is premature to make a judgment about what the ultimate capital impact is going to be from the operational risk charge.
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    Mr. TOOMEY. My next question for you, Mr. Hawke, is that you had mentioned earlier that you had previously argued against the Pillar 1 capital for operational risk, if I understand correctly. And I am not aware of what has changed with regard to the arguments that have historically been made against that. So I am just wondering what your thought process was to cause you to come to a different conclusion.
    Mr. HAWKE. Well, in part—and I do not mean to be facetious—but in part, it was deference to the shortness of life. I argued in the Committee for 4 years that because operational risk was a subject that involved the need to make qualitative judgments about a bank's internal control systems, it was appropriate to deal with it under Pillar 2.
    The Committee does not take votes, but I can tell you that there was nobody on the Basel Committee—25 people—who shared that view. It was not going to prevail. So rather than continuing to make the argument, we and the Fed worked together, I think very constructively, to develop the AMA approach.
    I am completely comfortable with the AMA approach to operational risk because I think it imports exactly that degree of supervisory discretion and supervisory qualitative analysis that I would have hoped for under Pillar 2. And I made the point earlier that even if this were a Pillar 2 issue, we would still have to have a framework for the supervisors to assess operational risk. My guess is that that framework would end up looking a lot like what we have in the AMA approach.
    Mr. TOOMEY. Okay. Well, thank you very much. My time is running out.
    I would be happy to recognize the gentlelady from New York.
    Mrs. MALONEY. Thank you, Mr. Toomey. Thank you. And I thank all of the panelists.
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    What I am most concerned about is the competitiveness feature. And apparently, all of you agree that it will not be a disadvantage to American financial systems.
    I would just want to know what proof there is. You mentioned we have had two quantitative studies. There is another one that will be ongoing.
    So I would like to ask Mr. Ferguson and Mr. Hawke, I would like to see the proof and the studies that you have done to make sure that American institutions are not disadvantaged. You testified that the capital requirement would be lower under the number two accord.
    Is that correct? Requirements for American banks? I heard someone say that. No?
    It will not be? Okay, but——
    Mr. HAWKE. That remains to be seen.
    Mrs. MALONEY. It remains to be seen. And what studies have you done and what proof do you have—beginning with Mr. Ferguson—to show that we will not be at a competitive disadvantage? What was your process to determine that?
    Mr. FERGUSON. First, what we are expressing is an opinion. We will be asking questions in the ANPR to determine how others view this.
    Let me explain a bit of how at least I have come to the opinion at this stage that——
    Mrs. MALONEY. Do you have anything in writing that supports your opinion? Any studies or research that support the opinion you came to?
    Mr. FERGUSON. Well, if you would let me, I will tell you what I have and then you can tell me if it is sufficient. Does that work?
    Mrs. MALONEY. Great.
    Mr. FERGUSON. Good. Here is why I had the view that I have. First, the reason we are engaged in an international exercise is to create a level playing field across nations. If we chose one capital approach and other countries chose another, the probability of an uneven playing field would go up.
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    So the entire goal of having an international accord that is hammered out over 4 years and has a variety of approaches that you have heard about, is to increase the probability of a level playing field internationally. Because large, internationally active banks will be on a comparable set of rules, by and large.
    Secondly, one of those rules involves transparency, which is to say banks disclosing not just the regulatory minimum capital under the set of rules, but also disclosing some of the inputs—not anything that is competitively sensitive, but some of the inputs—so that market analysts can observe the inputs of Bank A versus Bank B, whether or not the capital outcome looks the same. So it is not just that the rules are, broadly speaking, similar, but also the disclosure allows the market to do some comparisons across institutions.
    The third thing that we have tried to do in order to minimize the risk of disparities is create a process within this Committee, called the Accord Implementation Group that brings together the various regulators from around the world that are involved in this to talk about how they are making judgments on things, such as: How do you validate the inputs? What data does one look at? That type of thing, to try to create a strong sense of a level playing field among, if you will, the umpires, the regulators internationally. So that we, here in the U.S., are to some degree encouraging improved supervisory oversight that we think will come closer to ours, which again should give us some comfort.
    The fourth degree of comfort frankly is that if it turns out that this is not the case, that these three things I have just talked about are not the case, we will certainly hear from our institutions if they are feeling competitively disadvantaged. I have not heard that at this stage. But it will be the ultimate control.
    And finally, as I said, we will be asking questions to see if the industry or others see within the accord and the approaches that we are planning to take to implement it, any flat spots, any lacunae, any gray areas where they can see some room for competitive disadvantage.
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    I believe that those different approaches should be sufficient to give us a much better feel in response to your question. And you may have other questions. But that is the basis on which I have based the opinion I have so far.
    Mrs. MALONEY. Well, are you concerned that the vigor with which the Basel Accord is implemented in the U.S. by our regulators, which are very vigilant, could be a potential disadvantage for other international banks where their regulators are not as stringent? That could be a possible disadvantage to our banks.
    Mr. FERGUSON. Are you addressing that question to me or to someone else?
    Mrs. MALONEY. Yes, to anyone.
    Mr. FERGUSON. Well, I will answer. But then I would be more than happy to have some of my colleagues on the panel answer as well.
    Mrs. MALONEY. It may be applied differently in different countries.
    Mr. FERGUSON. That is the reason why we have developed this Accord Implementation Group, to try to create a more consistent application of this accord across borders. I would say one other thing as well, I believe that we have the world's strongest banking system, some of the most sophisticated banks.
    Mrs. MALONEY. Without a doubt.
    Mr. FERGUSON. Without a doubt.
    I believe that is partially the case because they are, by their nature, well managed. In fact, much of it is due to that.
    I think some of it is due to the fact that we have very solid regulators here that are pushing the best practice. I think there is—and one can look at other countries where their banking system is, to use a colloquial term, ''flat on its back'' because they have had frankly perhaps lax—too lax—regulations.
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    Mrs. MALONEY. Exactly, that is my point.
    Mr. FERGUSON. Exactly. But let me finish. I understand. And the point I am making is that a strong banking system does not result from lax regulation. A strong banking system results from good regulation.
    We are going to continue to do good regulation here, supporting a strong banking system. And, through this Accord Implementation Group, encouraging others to maintain a level of supervisory behavior —
    Mrs. MALONEY. In all due respect, I have noticed our country, through the United Nations and through other means, try to impress other countries with certain standards. And they really have not listened to us, from the Presidents, the premiers, their elected government. But I would like to hear from Mr. Hawke. I am specifically interested in written documentation that I can read that shows that our financial institutions will not be placed at a disadvantage.
    This is tremendously important to me. The financial system is the main employer in the district that I represent. And they are domestic banks, international banks.
    And I am concerned that there be some type of way, that either with this capital charge or the operational charge or whatever, we could be placed—or even with regulatory, more severe regulatory oversight, placed at a disadvantage. And I am interested in any written documentation that shows the process that we will not be disadvantaged.
    Do you know of any? Or have you done any, Mr. Hawke?
    Mr. HAWKE. Congresswoman Maloney, I do not know that there is any—or could be any—written documentation of the sort that you are asking for. Let me say that I completely agree with everything that Governor Ferguson has said. I think he gave a very complete and cogent answer to the question of competitive equality. The whole purpose of this Basel effort is to try to bring about competitive equality.
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    I do share the concern that differences in the nature of supervision from country to country could result in disparate application of Basel II, but the Accord Implementation Group will be one of the safeguards there. Frankly, I think the Basel Committee itself needs to address standards of supervision in member countries. That is certainly something that we will be arguing for.
    But I cannot hold out that there is any documentation that could be created or that exists of the sort you are looking for on these issues. We are going to be making a quantitative impact study that will look at the impact of Basel II on the capital of our banks. We will have to make a judgment whether that is acceptable or not acceptable and what it does to the competitiveness of our banks.
    Mrs. MALONEY. So that will be written evidence when you complete this study.
    Mr. HAWKE. That will be some evidence that will enable us to make a judgment, that is right.
    Mrs. MALONEY. Can I ask, Mr. Hawke, how would a regulatory capital charge, as contemplated by Basel II, have benefited a bank located near the World Trade Center on September 11th? Can you explain what benefit and operational risk-based capital charge could have played in preventing the financial impact of the terrorist attack?
    Specifically, are you concerned that requiring banks to hold capital for such extreme events as September 11th could divert resources from contingency planning and development of backup facilities?
    Mr. HAWKE. No, not at all. I think, with great respect, that pointing to the September 11th events and catastrophic events of that sort misses the point. The point is that every bank has operational risks that adhere in the nature of the business to one extent or another.
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    The objective is to focus banks' attention on how they manage those risks. How does the bank itself get prepared to deal with a whole variety of different types of operational glitches, whether it is the defalcation of a key employee or a system going down because of some external event? And the objective is to assure that the bank is holding capital that would help it protect itself against those risks. So you cannot really say that operational risk is going to do something specific with respect to a catastrophic event like——
    Mrs. MALONEY. Well, then another specific question for you and Mr. Ferguson on operational risk, as it now stands, the capital proposal includes a charge for the potential costs associated with U.S. tort liability, discrimination, suitability and similar laws that we have passed. Many of the protections are not available to individuals in the EU or Japan or other countries.
    In the U.S., these protections are the result of decades of work to promote civil rights. And do you think a capital charge for this will have an adverse competitive impact on U.S. banks and perhaps reduce the compliance efforts?
    In other words, is there a danger that we are encouraging other countries not to protect civil rights or undermining our own protections by requiring capital for these kinds of suits? And what is the evidence that the costs associated with litigation has resulted in a bank failure?
    Mr. FERGUSON. I guess I will take the first pass to that. And let me echo and reinforce something that Comptroller Hawke said.
    The purpose of having capital is not to prevent. We could not possibly with capital prevent something like September 11th. That is not what capital does.
    Mrs. MALONEY. I want to talk about the response from it.
    Mr. FERGUSON. Let me—let me——
    Mrs. MALONEY. Okay.
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    Mr. FERGUSON. The point of this focus, as Comptroller Hawke has indicated, on operational risk is that it is a real risk. In my statement, I have included 10 examples. A few of them were ones in which banks failed because of an operational problem—fortunately, small and medium-sized banks, not large banks.
    A number of them are examples where an operational failure, failure to comply with laws, failure to run a system smoothly, led to a large reduction in or could have led to a large reduction in capital, costing literally $600 million, $700 million—hundreds of millions of dollars. So part of the challenge here is to build a sufficiently strong capital base to deal with a risk of an operational failure.
    The advantage, as Comptroller Hawke implied and I will try to make clear, and we saw this on September 11th, is that institutions that have a strong capital base continue to have access to markets so they can get the liquidity that they need to keep their ongoing operations. It will not prevent a failure.
    Now the second part of it, the second reason to have this focus on operational risk and to have a capital charge associated with it, is that a number of banks have indicated and we have seen as an independent supervisory judgment, that the need to understand the operational risk that an institution might be subject to does, in fact, do just what you want to have does, in fact, do just what you want to have done. That understanding gives those banks an incentive to comply with laws, to build the kinds of safeguards to avoid defalcation, to move their backup sites to locations that are more secure, et cetera.
    All of that gets an advantage under these kinds of accords, the AMA that we are talking about. Or purchasing insurance also will give an advantage.
    So the entire structure of the AMA is meant to give incentives to make the investments, to comply with laws, et cetera, that you have indicated. It does not undercut it. In fact, it reinforces the kinds of good management behavior that you and we both want to reinforce in these operational areas.
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    Mr. HAWKE. Can I just add one point? I think there is some misconception about how this works.
    We are not going to tell a bank that they have to have an operational risk charge that deals with tort liability and another charge that deals with some other potential risk. We are going to be asking the banks, first of all, to assemble data about the kinds of losses that they have had in the past and to look at where the losses have been with other banks. We are going to be looking at their internal risk management systems and how they themselves address these operational risks.
    If tort liability is a risk that U.S. banks have that their foreign counterparts do not have, that is not caused by bank regulators. That is caused by our legal system. The practical reality is that it is a risk that our banks have that other banks do not have. The question that we ask is how are our banks managing that risk? How are they responding to that risk? The idea of an operational risk charge is to make sure that the capital base of our banks takes into account the whole variety of operational risks that our banks face.
    Mr. FERGUSON. And one other thing, international banks that operate here in the U.S. should be holding capital for the kinds of risks they face here in the U.S. And so if they are operating in the U.S. and are subject therefore to the kinds of concerns that you have just raised, one would expect, their regulators should expect and we should expect their local subsidiaries, if they are on this approach, to be holding capital. So there is no international inequity that would emerge in this.
    Mrs. MALONEY. Okay, my time is up. But these small banks that you say failed would not have been covered by Basel II.
    Mr. FERGUSON. There are large banks. The whole goal here is not only to avoid failure. It is also to deal with having a capital cushion so that when you have a large hit of hundreds of millions of dollars, and if you look at my chart, you see hits as big as $1.2 billion—$1.1 billion, $1.3 billion you can survive.
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    It is true, medium-sized banks have failed. But it is also true that large banks have been asked to leave the United States or have had a change of ownership or have also had some difficulties, for which we want and they should have a capital base, even if they do not suffer a failure.
    One should not think of this as an on-off switch. Either you fail or you do not. There is also a risk of a severe reduction in capital for which you want to build a cushion to avoid failure.
    And so you should not think of this as purely: did they fail or did not they fail? You should also think of whether or not you need the capital base to keep ongoing operations and avoid failure. And that is what capital does. It allows you to continue in the market and continue to thrive, to fund yourself.
    So that failure is not the only test that matters here. It is also significant loss of hundreds of millions of dollars that would eat into the capital base.
    And there is a great deal of evidence of losses of the $400 million, $500 million, $600 million amount, that we as regulators should not simply ignore because it was not a failure.
    Mrs. MALONEY. My time is up.
    Chairman BACHUS. [Presiding.] Thank you.
    Mr. Ferguson, I am going to ask you one question. Then Mr. Watt will conclude the panel's questions.
    You have indicated on page five of your testimony that we have concluded that despite our supervisory judgment on the potential risk of these exposures—I am talking about the commercial real estate loan capitalization—that we could not support requiring a higher minimum capital charge on these loans. And we will not do so.
    What do you see the final standards will look like on the capital charge for commercial real estate?
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    Mr. FERGUSON. The proposed accord has the possibility of two different types of capital charges for commercial real estate, some higher and some lower, depending on the nature of the real estate. Based on the data that has come forward—and there may be some new data that comes—but based on the data that has come forward, I believe the proposal will have most commercial real estate on what is called the low volatility curve or a lower curve that is similar to the C&I, the commercial and industrial loan curve. And that is, I think, quite consistent with the input from a number of banks.
    There may be some kind of high volatility real estate—acquisition, development and construction loans of certain sorts—where the data still suggests they should have a slightly higher charge. But I think the vast majority of commercial real estate will be on the lower curve and have a charge similar to commercial and industrial loans.
    Chairman BACHUS. And you know I have expressed my concern to you before. And I appreciate the changes that you all have made, based on this new evidence.
    We do not want to retard growth. And in some areas of the United States, they are growing very rapidly. And you mentioned construction loans. Obviously, that is new construction. And that is evidence of growth.
    And I hope that you will continue to look at that.
    I am not sure that construction lending, in my mind, is as risky—and I am just anecdotally—because that represents someone's investing in a new project.
    Mr. FERGUSON. We do not want to retard growth at all. We want capital to reflect risk. And as you know, because you were referring to it, when the data come in, we change our minds if the data are supportive of a change of opinion. We will continue to watch this pretty closely.
    We have already shown a great deal of flexibility. And if new data sets suggest that we should rethink the position we have now, you have my commitment that we will do that because we have already given evidence that we have done it in the past.
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    Chairman BACHUS. Because as you know, we have states that are growing at 20 percent every 10 years in population, unlike most parts of Europe, where they do not have those.
    Mr. FERGUSON. Well, this is an area, sir, where there is national discretion. So we will develop a capital approach with respect to real estate and these two different curves that reflect U.S. data primarily.
    Chairman BACHUS. Thank you.
    Mr. Watt?
    Mr. WATT. Thank you, Mr. Chairman.
    I want to assure the Chairman that I will not take the full 10 minutes, unless you all take it answering two questions. And I want to apologize to the witnesses for not being here for the testimony.
    Unfortunately, I would much have preferred to have been here. I was in a hearing about whether we should prohibit lawsuits against—on behalf of people who get fat against McDonald's and other fast food providers.
    No pun intended, a very heavy responsibility.
    Just two questions. First of all, I have noted in Mr. Ferguson's testimony and Mr. Powell's testimony—and I did not get a chance to look at Mr. Gilleran's testimony. I did not see anything on it in Mr. Hawke's testimony. At least Mr. Ferguson and Mr. Powell think that H.R. 2043 could be counterproductive.
    I wanted to see if that was the uniform opinion of everybody on the panel. I have Mr. Ferguson and Mr. Powell. What about Mr. Hawke?
    Mr. HAWKE. Congressman Watt, in my oral statement, I said that while I am sympathetic with the underlying concerns that led to H.R. 2043, we did not think that it was necessary at this time. There has been a very collaborative process that has been followed by the regulators. There are dozens and dozens of issues that come up, most of which we agree on, some of which we do not agree on. The need for some external process to force resolution of issues, I think, is not there.
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    We have a collaborative process going forward that is going to involve joint notices of rulemaking and joint publication of supervisory guidance. I think we are very much together on these issues going forward.
    In addition, there is an executive order that requires certain kinds of economic analysis to be made in connection with any rulemaking that would have a substantial effect on the economy. That is defined to mean an effect of $100 million or more annually. We will be soliciting comment in our Advance Notice of Proposed Rulemaking to give us the information to determine whether this rulemaking will actually have that kind of impact. And if it does, then much of the same kind of economic analysis that would be called for in H.R. 2043 would be provided under that executive order.
    So, with great respect, we do not think that legislation of this sort is needed at this time.
    Mr. WATT. Mr. Gilleran?
    Mr. GILLERAN. As I said in my written testimony, to the extent that the OTS is mentioned in it, we completely agree with it, and that is that we be part of the process going forward. I think that the regulators have shown——
    Mr. WATT. Have you not been part of this process?
    Mr. GILLERAN. We have not been part of the international process up until this time. We have been part of the working groups here in the United States. And we will be part of it going forward, in the sense that we will be a party to the ANPR that we have put out and the deliberative process that will take place going forward. So your support in that regard is welcome.
    On the issue of how this decision is made going forward, I believe that the regulators have shown the ability to cooperate, to deliberate and come to very, very reasonable conclusions. So that I believe the process of Basel II, with your strong oversight and interest, I believe your interest has made a difference already. And I believe the Senate Banking Committee's interest has made a difference.
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    But I believe that the process, going forward, should be left to the bank regulators.
    Mr. WATT. Now while you have the floor, I noticed that when Ms. Maloney was asking questions, you raised your hand at one point. And apparently, nobody saw you. I wanted to make sure you got a chance to make the point, whatever that point was, that you wanted to make.
    Mr. GILLERAN. Thank you. Well, I was just going to, on the point of international competitiveness, I wanted to react to that. Because in a prior career, I was superintendent of banks in California and worked with a great number of international regulators.
    And it is my view, as has been already expressed here in our written documents and in person, that the United States is the strongest bank regulator, without question. And we have countries out there where bank regulation is weak and that they have not applied concepts that we apply here in the United States correctly.
    There are countries out there that have not written off loans and that are just starting to react to the loans they have in their bank portfolios now. Their inability to have a strong international banking system has been to their detriment.
    Because what has happened in those countries that do not have one is that they have a misallocation of capital within the country. They keep funding companies that are losing and not funding new technology.
    So I think that they are the biggest losers of not correctly allocating capital. And I believe that since there are countries that are not doing it well now, there will be countries that will be not doing it well in the future.
    I do not think it disadvantages the United States or United States banks because I think we are the winner for strong bank supervision.
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    Mr. WATT. Thank you.
    Finally, a natural segue from my first question about H.R. 2043 and your responses to the need for that, in general, is there anything that you can identify that this Subcommittee, the full Committee or Congress needs to be doing as you keep going through the schedule that is outlined in your testimony? And if there are any things that we need to be particularly aware of, it would be helpful for at least me to know that.
    Mr. HAWKE. I think, Congressman Watt, that the Financial Services Committee's involvement has been very healthy for this process. It has certainly strengthened our hand in the Basel discussions.
    Some of the other countries that are participating in this process have had their legislatures involved from the very outset. And some members of the Basel Committee were constrained in the positions that they could take in the Committee by their parliaments right from the beginning of the process. We were not. We have worked together as a group of regulators and participated in that process.
    But I welcome the oversight and the interest of the Committee in the process. I think the Committee's continued dialogue with the regulators is important. I think ultimately, it will strengthen our position vis-a-vis the Basel Committee. We look forward to it.
    Mr. WATT. Mr. Powell, anything else you can think of that we need to be doing? Mr. Gilleran? I am going to come back to Mr. Ferguson and give him the last word on this.
    Mr. GILLERAN. I think you should continue what you are doing. I think your interest and your oversight is important to us. I think that we should have a meeting like this sometime in November or early December, so that we can report back on our findings and assure you that whatever those findings are, that we are in a position to go forward.
    Mr. WATT. Mr. Ferguson?
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    Mr. FERGUSON. I would echo many of the comments from Comptroller Hawke. And I would add one other, which is that in a democracy, it is extremely important, I think, to have these kinds of hearings, to give some legitimacy to a regulatory process.
    I realize that I and we have all been appointed by the President and confirmed by the Senate. But to have both sides—Senate and House—asking tough questions and being educated, I think gives us a greater sense of legitimacy to the industry overall because they know that we have had to come here and deal with some very tough questioning.
    And I think, therefore, this kind of oversight is very useful, not just because of the ability to talk to our negotiating partners overseas about the messages we are receiving, but also frankly our ability to talk to each other and to the U.S. population about the fact that indeed, we have gone through a full process that has not just the usual external comment period, but this kind of give and take. So I do also endorse your interest and thank you for the opportunity to——
    Mr. WATT. Any suggestions about any other things we need to be doing, other than maybe getting a follow-up report at some point?
    Mr. FERGUSON. I would say—well, there are two things that I am sure you will do. One is I am sure you will keep those cards and letters coming. And so, by definition, I welcome that.
    And secondly, I think——
    Mr. WATT. Only to the extent our banks keep those cards and letters coming—and constituents keep those cards and letters coming.
    Mr. FERGUSON. And I am sure they will because that is what this is all about. And I would say just asking for feedback in the form we all collectively think would be appropriate, obviously is the other thing.
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    Mr. WATT. Thank you.
    Chairman BACHUS. Thank you, Mr. Watts. At this time, we will discharge the first panel. We very much appreciate your testimony. And I very much agree with you that the Committee's activity has been productive.
    So I appreciate all of your candor and participation in this important issue. And we are confident that you all will come to a consensus.
    Thank you.
    At this time, we will call our second panel. I want to welcome our second panel. I am actually going to introduce three of the panelists. And then Ms. Hart is going to introduce Mr. Elliott.
    The first panelist or the second panelist, seeing as Mr. Elliott is going to be introduced by Ms. Hart, is Dr. Benton Gup. He is the Chair of Banking at the University of Alabama. Prior to that, he was the Chair of Banking at both the University of Virginia and the University of Tulsa.
    Prior to that, he was a staff economist for the Federal Reserve Bank of Cleveland and has been the author of so many books, it would be impossible to list them, many of them used widely in the banking industry and also in the university. His publications have appeared in a number of journals.
    So we welcome you, Dr. Gup.
    Mr. GUP. Thank you.
    Chairman BACHUS. Our second panelist or our next panelist is Micah Green of the Bond Market Institute. And I notice, between our third and fourth panelists, is that you both have your doctorate degree from George Washington University, so both graduates. That is correct, isn't it?
    Mr. GREEN. My law degree. But thank you for the——
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    Chairman BACHUS. Law degree. I consider that a graduate degree or post-graduate degree. Micah Green is President of the Bond Market Association. That is an association of 220 member firms, which collectively account for 95 percent of the nation's municipal security underwriting and includes all the primary dealers and other key participants in the U.S. government and federal agency security market and all major dealers and municipal and corporate debt securities, mortgage securities and money market instruments. And you will be testifying on behalf of the Bond Market Association.
    He received his J.D. and bachelor's degree from George Washington University.
    Our final panelist is Ms. Karen Thomas. She is Director of Regulatory Affairs and Senior Regulatory Counsel for the Independent Community Bankers of Alabama—not of Alabama, of America, a national trade association representing 5,000 community banks. She has frequently published articles in the Wall Street Journal, American Banker and quoted in American Banker and BNA's Report for Executives and appeared on numerous TV shows—CNBC, Nightly News, et cetera.
    You are a graduate of the College of William and Mary and received her J.D. with honors from George Washington University's Law Center. So you are both law graduates from George Washington.
    So I welcome you both.
    At this time, I am going to turn the chair over to the gentlelady from Pennsylvania, Ms. Hart. And we will try to expedite this hearing. Thank you.
    Ms. HART. [Presiding.] Thank the Chairman also for allowing me to introduce Mr. Elliott, who is from my area. Steven G. Elliott is Senior Vice Chairman of Mellon Financial Corporation. He is responsible for the corporation's asset servicing and human resources services businesses, including global security services, securities lending, foreign exchange, Mellon investor services, Buck Consultants and Mellon HR Solutions.
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    The corporation's finance, treasury, technology and real estate and Mellon's venture capital businesses also report to Mr. Elliott. And he serves on the Board of Directors of Mellon Financial Corporation and also on the Board of Directors of Mellon Bank, N.A.
    Mr. Elliott joined Mellon in 1987 as Executive Vice President and head of the Finance Department. He was named CFO in 1990, Vice Chairman in 1992 and Senior Vice Chairman in 1998. There was clearly no age requirement for that job.
    Previously, Mr. Elliott served in executive positions at First Commerce Corporation, Crocker National Bank, Continental Illinois National Bank and First Interstate Bank of California. He is a member of the American Institute of CPAs, the Financial Executives Institute and the Financial Services Roundtable.
    He also serves on the boards of the Pittsburgh Cultural Trust and the UPMC Health System. That is the University of Pittsburgh Medical Center Health System.
    He is a native of Delta, Colorado. Mr. Elliott also received a bachelor's degree in finance from the University of Houston and a master's in business administration from Northwestern University's Kellogg School of Management.
    I will also add, it is nice to see the reverse migration from Colorado to Pittsburgh, instead of from Pittsburgh to Colorado. Thank you for joining us also, Mr. Elliott.
    Is that a vote? Okay. We are going to have a vote. But I am going to let you start, Mr. Elliott. And we may suspend in just a little while so that members can actually get over to the vote.


    Mr. ELLIOTT. Thank you very much, Representative Hart.
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    Mellon is a financial services company with 22,500 employees in 21 countries. As indicated, we provide institutional asset management, mutual funds, private wealth management, asset servicing, human resources and treasury services. Mellon has approximately $2.9 trillion in assets under management, administration or custody, including $566 billion under management.
    It is indeed a pleasure to appear today before you to discuss our views on the pending changes to the capital, supervision and disclosure rules. Although complex, sometimes very much so, these new rules will have a profound impact on the competitiveness of U.S. financial services firms and on the products they provide to American consumers, companies and investors.
    Basel will have a particularly dramatic impact on Mellon's lines of business, where U.S. banks now have a global comparative advantage through aggressive investment and leading edge technology and the sophisticated risk management and related systems developed to support these activities.
    Basel's rules also will have a profound impact on the global economy. Although the rules are not now scheduled to go into effect before 2007, they will in fact have a major impact on financial markets far more quickly. Thus, your review—and that of other panels in the Congress—is timely and commendable.
    At the outset, I would like to express Mellon's gratitude to all of the regulators—U.S. and global—that spent literally thousands of hours crafting these revisions. Of particular note is the new emphasis on a more balanced approach to bank regulation—what Basel is calling the Three Pillar Approach.
    I strongly agree that capital rules are not the sole touchstone of bank safety and soundness. Indeed, undue reliance on capital adequacy can divert attention from latent, serious problems in internal controls, strategic decision-making and other key risk areas.
    Thus, Basel's decision to look not only at capital, but also at supervision and disclosure, will result in a far stronger global financial system going forward. All of the hard work is also justified by the worthy goal with which Basel started: an end to regulatory capital arbitrage.
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    All sophisticated banks and their holding companies—Mellon included—have gotten better in the past decade at spotting inconsistencies between the regulatory capital standards that bind us and the economic ones that are demanded by the broader markets. Better alignment of regulatory and economic capital will reduce this dichotomy and ensure that capital requirement incentives promote the laudable supervisory goal of increased bank safety and soundness.
    Unfortunately, since Basel started, its goals appear to have changed. As recently stated in a document released by U.S. regulators, the Basel goals now are improving internal controls and capital allocation, promoting market discipline and adding a new capital charge for operational risk.
    Mellon strongly supports the first two goals. But the third—a new one—in fact undermines the first two by creating perverse incentives to undue risk taking. The operational risk-based capital requirement could also put U.S. banks at a serious competitive disadvantage versus non-banks here—and I want to emphasize versus non-banks here—and non-U.S. financial services firms around the world.
    The U.S. decision not to impose the most flawed operational risk-based capital proposals does not negate the fact that these will be mandated elsewhere, with potential serious safety-and soundness results. Setting operational risk-based capital as a simple percentage of gross revenue creates perverse incentives to risk taking, as I have mentioned in my written testimony. And the U.S. should fight hard against this in Basel II to ensure that all of the world's large banks are under a proper regulatory capital regime, not just those here in the United States.
    Systemic risk must be an overriding consideration as Basel II is finalized. And the operational risk-based capital proposal thus poses especially serious challenges, in our view. As requested by the Subcommittee, I shall focus my comments today on issues of particular importance in the U.S., with a focus on recommendations for the pending advance notice of proposed rulemaking to be released by the bank regulators.
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    I would recommend: first, complete elimination of the Pillar 1 operational risk capital charge. The goal of promoting internal controls and capital allocation can far better be achieved through addressing operational risk-based capital in Pillar 2; namely, improved bank supervision.
    Second, the U.S. should not force all large banks into the most advanced versions of Basel II, as these are also the most complex and not necessarily appropriate for all large banks. Specialized banks like Mellon, for example, which holds less than $5 billion of loans in our lead bank, do not require the advanced internal ratings-based approach for our credit book. The standardized approach for credit risk that will be used by the European Union appropriately controls regulatory arbitrage for specialized banks.
    Third, there is no need to continue the arbitrary eight to 10 percent capital ratio or the overall leverage capital standards. To achieve the end of the regulatory arbitrage that Basel and the U.S. regulators rightly seek, low-risk banks should hold regulatory capital appropriate to this position, which could be well below current regulatory levels set in 1988.
    On the other hand, high-risk banks should similarly hold the appropriate amount of capital, likely far more than what they currently do. A simple, overall capital ratio undermines the goal for which Basel and the U.S. have worked so hard for so long.
    Finally, operational risk-based capital should not be used as a Pillar 1 or a Pillar 2 top off to credit risk capital. Each bank should hold regulatory capital appropriate to its risk profile, with market forces and the bank's judgment determining when more than the risk-determined amounts of capital be held.
    Thank you. And I would be pleased to answer any questions.

    [The prepared statement of Steven G. Elliott can be found on page 66 in the appendix.]
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    Ms. HART. Thank you, Mr. Elliot. At this time, we are going to recess the Committee so that the members can vote. And we are going to reconvene at 1:45, with a pretty long series of votes. So if the panel wants to maybe grab lunch or something, feel free to do that.
    But we will be back at 1:45.
    Chairman BACHUS. [Presiding.] The Subcommittee on Financial Institutions and Consumer Credit will come back to order. I apologize to our panelists for the interruption. We had votes on the floor.
    It is my understanding, Mr. Elliot, that you testified.
    And Dr. Gup, we look forward to your testimony. And I recognize you at this time for your testimony.


    Mr. GUP. Mr. Chairman and members of the Committee, thank you for the opportunity to testify here. I am going to summarize my written comments that I would like included in the record.
    The 1988 Basel Accord provided a minimum capital standard of eight percent of risk weighted assets for internationally active banks to ensure an adequate level of capital and provide competitive equality. The ''one size fits all'' capital standard was a good starting point.
    But as banks face a growing range of risks and new technologies, it became clear that the capital requirements had to be made more risk sensitive. The result is Basel II.
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    Federal Reserve Vice Chairman Ferguson said on June 10th that regulators expect to require 10 or more of the largest banks to use the Basel II Advance Internals Risk-Based approach for credit risk. Other large banks may elect to use the Advanced IRB approach. And the remaining banks will continue to use the 1988 capital standards.
    In my written testimony, I said the regulators would require about 20 banks to meet the new standards. The difference in the number of banks required to use the advanced IRB does not affect my conclusions.
    The major point is that about 70 large banks, with assets of $10 billion or more, those banks whose stocks are actively traded believe that if they want to be considered major league players by equity analysts and their stockholders must use the advanced IRB approach. In addition, they must declare that they are using it in their financial reports.
    The advantage to banks using the advanced IRB approach is that they may have lower capital charges on certain loans than banks using the 1988 capital standards. This creates competitive inequality.
    The disadvantage is the high cost of implementing Basel II, which ranges from $10 million to $150 million.
    The treatment of real estate loans in Basel II is another problem because real estate loans constitute a large portion of the portfolios of large regional banks. The U.S. bank regulators' perception of risks associated with real estate loans are based in part on the loss experiences of the late 1980's and early 1990's.
    During that period, the losses on real estate loans were highly concentrated geographically in Texas, Massachusetts and Connecticut and mostly in small banks. It is important to keep in mind that this occurred before deregulation and significant changes in financial technology.
    Thus, looking at the 1980's and early 1990's to determine capital requirements for today is analogous to driving down a steep, winding mountain road by only looking out the back window; a crash is inevitable.
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    Today, real estate lending at large regional banks is different for the following reasons: banks can expand geographically and avoid excessive concentration; they can buy or sell mortgages via securitization; they can hedge with derivatives; they can have low loan-to-value ratios and they can use high credit scores, such as FICO scores.
    Fannie Mae and Freddie Mac provide examples of how these tools may be used. In addition, Fannie Mae and Freddie Mac have only three percent capital requirement.
    In conclusion, the Basel II capital requirements create an uneven playing field, giving an advantage on capital charges to those banks using the advanced IRB approach. The capital charges on commercial real estate loans in Basel II are excessive. A risk weight of 150 percent may mean that a bank must hold more than eight percent capital on such loans.
    However, as noted previously, banks can manage their portfolios using the same tools as Fannie Mae and Freddie Mac. And these government-sponsored entities have only three percent capital requirement.
    The bottom line is that there will be competitive inequality in bank capital under Basel II.
    Thank you very much. And I will be glad to answer any questions.

    [The prepared statement of Benton E. Gup can be found on page 128 in the appendix.]

    Chairman BACHUS. Appreciate that.
    Mr. Green?

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    Mr. GREEN. Thank you, Chairman Bachus, for the opportunity to testify today on Basel II.
    As you indicated earlier, the Bond Market Association represents the U.S. and global bond markets. Together with our affiliates, the American and European securitization forums, we also represent many of the major participants in the growing securitization markets in the United States and Europe.
    The following comments focus on those issues related to Basel II that are most important to our membership. First, let me say the association supports the Basel Committee's overall goal of rationalizing the current risk-based capital regime and aligning regulatory capital requirements more closely to actual risk.
    We are grateful to the Federal Reserve Board in particular, Vice Chairman Roger Ferguson and other U.S. bank regulatory agencies for working with us to address the issues presented by the proposed capital accord revisions that are important to our membership. We are still concerned, however, that if not amended, Basel II will diminish the economic benefits derived from large and growing sectors of the capital markets, benefits which accrue to consumers, as well as businesses.
    And I also want to congratulate you, Mr. Chairman, and Chairman Oxley and Congressman Frank, for bringing this Committee hearing together today. It really has been important to the process of elevating the dialogue between regulators, the Congress and the affected parties. And I think it is a very positive development.
    I will first make one general comment on the direction of Basel II and then focus on two areas of most importance to us—securitization and the repurchase agreement and securities lending market.
    With regard to Basel II broadly, we believe it is important that this agreement not be viewed as the last word on regulatory capital. Risk management techniques are continually evolving. And the financial markets need a regulatory capital accord that evolves with them.
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    Basel II must therefore be crafted in a way that ensures it can better adapt to changing market products and development. Ultimately, the global financial community will need to move toward a broader reliance on internal risk models to determine appropriate capital levels.
    On securitization, which is a process of converting illiquid financial assets, like loans or other receivables, into securities which can be traded in the capital markets, it is a large and growing marketplace, with tremendous economic benefits for consumers and businesses.
    Securitization lowers borrowing costs for consumers and others, improves risk management, draws new sources of capital to the lending markets. Consumers benefit from these efficiencies with lower interest rates; in a sense, bringing the high finance, the technology of finance down to the consumer level through lower cost home mortgage.
    To give you an example of the size of the markets, in the last 7 years, the U.S. securitization market has grown fivefold to $2.7 trillion. In Europe, it has grown twentyfold—to a smaller level—but twentyfold to $151 billion. And in Asia, where the securitization market is just getting started, it has grown in the last 7 years 510-fold to $51 billion.
    Financial institutions participate in this marketplace as issuers and investors and as part of their risk management functions. For securitization generally under Basel II, the proposed risk weights for securitization positions held by banks are simply too high in light of the actual credit risk presented by these products.
    The proposed rules use unrealistically conservative assumptions that cumulatively would require financial institutions to set aside excessive levels of capital. Considering who ultimately benefits from a vibrant securitization market—home and car buyers—this is very important.
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    These concerns must be addressed. And they are addressed fully in our written testimony.
    Lastly, repo and securities lending transactions, although little known outside the wholesale financial markets, are vital to our capital markets' liquidity and efficiency. Repo and securities lending transactions allow market participants to finance and hedge trading positions safely, cheaply and efficiently. In fact, the Federal Reserve uses this marketplace to implement monetary policy.
    Basel II may require banks to take capital charges inconsistent with the actual level of risk present in repo and securities lending transactions. Financial institutions should have greater flexibility to employ supervisory-approved internal risk models created to assess counter party risk in order to accurately reflect risks present in these transactions. These issues are also dealt with in more detail in my written testimony.
    And finally, we agree completely that the current regulatory scheme for bank capital—Basel I—needs significant revision. The current regulations are outdated and inflexible.
    Updating the regime can produce significant benefits, including the promotion of fair global competition, incentives for better internal risk management and an economically efficient allocation of capital. Getting it wrong, however, and implementing capital regulations which do not reflect modern practices or true credit risks on banks' balance sheets will diminish or eliminate market efficiencies that benefit everyone.
    The Basel Committee is on the right track in developing new capital standards. But significant work still needs to be done.
    In order to preserve the efficiency of our capital markets, the treatment of securitization, repo and securities lending products, it needs to be amended. We intend to continue our active dialogue with U.S. and international bank regulators on the issues addressed above. We have every hope that these issues can and will be resolved before Basel II becomes final.
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    Thank you for the opportunity to testify, Mr. Chairman.

    [The prepared statement of Micah S. Green can be found on page 122 in the appendix.]

    Chairman BACHUS. Thank you. I would say this, Mr. Green, securitization, which we also are hearing that a lot in our FCRA hearings, because with many auto loans, as well as mortgage loans and in consumer loans, securitized, it is important that we have a national uniform credit reporting system too.
    And I had heard, in those hearings we have been conducting, amazing testimony on how much that does bring down interest rates. It is quite amazing. So I just point that out. I appreciate that.
    Ms. Thomas?


    Ms. THOMAS. Mr. Chairman, thank you very much. I am pleased to appear today on behalf of the Independent Community Bankers of America, to discuss Basel II and its implications for community banks in the United States.
    First and foremost, ICBA applauds the U.S. regulators for their announced intention to limit the scope of application of Basel II in the U.S. and not to require it for second-tier and community banks. Capital adequacy rules must be appropriate to the size and complexity of operations of the bank.
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    The Basel I Accord has worked well for community banks and generally remains well suited to assess capital adequacy for these banks. The significant and far-reaching changes to the capital adequacy framework contemplated by Basel II are unduly complex and costly for U.S. community banks and would be unnecessarily burdensome.
    Stated simply, Basel II is overkill for non-complex community banks. And the cost and burdens of adhering to Basel II would outweigh the benefits—if any—of moving to the new accord.
    The internal ratings-based approach is simply infeasible for community banks. Community banks do not have the resources to use costly, sophisticated internal risk rating models.
    A community bank is not likely to have a sufficient volume of credits to maintain a sophisticated, statistically valid model with sufficiently meaningful risk refinement to justify the high cost of extensive data collection, recordkeeping and model maintenance.
    The standardized approach, despite its additional complexity over Basel I, may not materially affect a non-complex bank's minimum capital requirements once the additional charge for operational risk under Basel II is taken into account. But as with any change, the standardized approach would present the burden of learning and mastering a new scheme, changing systems and software, and retraining management, boards and employees with little corresponding benefit to justify the cost for community banks.
    Even though we are pleased with the decision regarding the scope of application of Basel II in the U.S., that does not mean we do not have some concerns about the impact of Basel II on community banks. In particular, we are concerned that Basel II may place community banks at a competitive disadvantage.
    Basel II will yield lower capital requirements for retail credit, including mortgages and other loans to individuals and small businesses. These are the very credits where community banks compete with large banks.
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    Regulatory capital is a key factor in profitability and return on equity. There is a cost to a bank for maintaining capital. The lower capital requirements for retail credits may result in a cost advantage and correspondingly, a pricing advantage for large banks that are subject to Basel II.
    Our concern is heightened by the Quantitative Impact Study 3, which compares the average risk weights and capital charges under Basel I and Basel II. Total retail credit capital charges under the advanced IRB approach are estimated to decrease by 50 percent, including 60 percent for mortgages and 41 percent for non-mortgages.
    ICBA urges U.S. regulators to examine the question of competitive impact on Basel I banks closely. Small and medium-sized institutions play an important role in the economy by providing credit to consumers and small and medium-sized businesses.
    For this reason, it is imperative to consider the competitive impact and implications Basel II will have for second-tier and community banks, as well as for their customers. To balance any competitive inequities, regulators may have to consider making appropriate adjustments for Basel I banks, such as additional risk buckets or changes in risk weights to increase risk sensitivity.
    In addition, regulators should consider whether to allow second-tier banks and community banks the option to apply the Basel II standardized approach in order to avail themselves of its lower risk weights for retail credit. Problems with the operational risk charge under a standardized approach would have to be addressed, however.
    In sum, ICBA supports limiting the scope of application of Basel II in the U.S. At the same time, the concerns about competitive equity between Basel I and Basel II banks must be carefully examined and addressed.
    Thank you for the opportunity to appear before you today. I would be happy to respond to your questions.
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    [The prepared statement of Karen M. Thomas can be found on page 182 in the appendix.]

    Chairman BACHUS. Thank you. I am going to ask the first two questions of the entire panel. And I will start with Mr. Elliott and answer in order. And you do not have to, if you do not want to respond to either one of these two questions, you do not have to.
    First, would you share with the Committee your organization's involvement in the development of the Basel Capital Accords and the third consultative paper, if at all. Did you meet with all the regulators involved? Or only with some of them? And do you feel that the concerns you raised were properly addressed in the third paper?
    Mr. ELLIOTT. At Mellon, we have been very actively involved in not only the most recent paper, but all of the previous papers as well. I had a number of dialogues with the regulators. For us, our primary regulators are the Comptroller of the Currency and the Federal Reserve Board.
    Not only have they visited us at our headquarters in Pittsburgh, but we have gone to a series of outreach meetings that they have conducted. And there has been a lot of ability to be part of the process.
    So I think from a process perspective, Mellon is comfortable that the regulators have been giving us adequate opportunity to have our views heard.
    Chairman BACHUS. Were your concerns addressed?
    Mr. ELLIOTT. No. We still have a major concern as it relates to the operational risk charge. Part of it obviously is with our mix of businesses, where we do very little lending directly. And thus, the operational risk issue becomes larger.
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    And the one in which we have difficulty is that most of our competitors, many of them are non-banks and would not be subject to the same type of capital requirements, not only here, but also globally. And a lot of the risks that are currently part of Pillar 2 supervisory, like interest rate risk, liquidity risk, strategic risk, these will continue to be dealt with in Pillar 2.
    And we are puzzled, if you will, as to why operational risk by itself is being singled out for an explicit capital charge. Our view is that it should be back in Pillar 2, along with these other major type of risks that affect all institutions.
    Chairman BACHUS. So you feel like this could actually put you at a competitive disadvantage?
    Mr. ELLIOTT. Yes, we do.
    Chairman BACHUS. Dr. Gup, I do not guess—you have not actually been part of the process?
    Mr. GUP. Well, the University of Alabama has no direct interest in this.
    Chairman BACHUS. Sure.
    Mr. GUP. I have a research interest in this. I am working on a book of selected readings and invited articles by myself and others on the subject of Basel. We will have a panel that presented some of this in a meeting last week in Ireland, dealing with Pillar 3, which has not been discussed here.
    At the Financial Management meeting in Denver in October, we are having a panel of government regulators, academics and others, practitioners, discussing Basel II. The following year in Zurich, we are having another panel on this.
    So we are presenting a wide variety of views. I will be presenting some of my views also to the Australian Institute of Banking and Finance, which is like the American Bankers' Association Down Under, later this summer. So we are getting a global perspective. And I am trying to get some research input into this area.
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    Chairman BACHUS. You said that you talked to your colleagues in Europe about Basel II when you were in Ireland?
    Mr. GUP. Asia, all over. Yes, sir.
    Chairman BACHUS. What can you share with the Committee about what you learned over there in Ireland?
    Mr. GUP. I could not find anybody that likes it. Everybody seems to agree that Basel I is outdated and we have to move forward. But the degree of complexity is a major disadvantage of using Basel II. It has a lot of problems.
    It is a good starting point. It is a work in progress.
    Chairman BACHUS. So the Europeans have some of the same concerns?
    Mr. GUP. Absolutely.
    Chairman BACHUS. Okay.
    Mr. Green?
    Mr. GREEN. Mr. Chairman, the Bond Market Association, since our principal focus—not our sole focus, but our principal focus—has been around the product areas I mentioned, has been deeply involved for a long time, particularly in the United States, working with the Federal Reserve, as well as the New York Fed, where President McDonough was so deeply involved in the Basel Committee for many years. And there has been very good dialogue over that period of time.
    Also, since the U.S. securitization market was so well formed already, there was a sense that the European participants in Basel may not be fully aware of the impact that would have on the European securitization market. And our affiliate organization, the European Securitization Forum, which is a purely European-based organization, has had regular ongoing dialogues with European regulators to try to ensure that they have a full and complete understanding of that market. And together, we have also had discussions with them on the repurchase agreement side.
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    Also, the Bond Market Association, both through its office London but also in its membership in the International Council of Securities Association, which is made up of 25 or 26 various associations and self-regulatory organizations from around the world, meets a couple of times a year. And Basel has been a subject matter of discussion for many years to ensure that, at the association representational level, there is some degree of coordination.
    Are we there yet? I am not sure we would be here testifying, saying that it needs improvement, if we were fully satisfied with the Third Consultative Paper.
    Our hope is that on the issues that we have talked about on securitization and repurchase agreements, that between Third Consultative Paper and the final Basel agreement, there will be continued improvement to address those issues. Because the issues that we feel are our focus affect real people and consumers who need to buy homes and buy cars and need access to capital.
    In fact, the University of Alabama may, in fact, care about that. And we would hope that before Basel is complete, these issues can be addressed.
    Chairman BACHUS. If the Basel Accord went into effect, as presently constituted, and there are no more changes with regard to securitization, what will be the impact on the securitization market?
    And number two, will the Bond Market Association support Basel II, even if the changes you have suggested are not adopted or included?
    Mr. GREEN. Answering your second question first, there is unanimity among the market participants in our organization that Basel I is outdated and inflexible. And therefore, the status quo is not good.
    The general direction of Basel II is very promising. And the specifics—in a sense, the details—need improving. But the general direction is an improvement upon the status quo, which is why we are supportive of the general direction of Basel II.
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    If the issues that we have raised are not fixed, the impact would be focusing on securitization. Financial institutions, if they have to charge more risk capital on their balance sheet than what is appropriate, based on the actual risk, then their ability to participate in that marketplace will be hampered.
    The depth of liquidity in that marketplace will be hampered. That affects the pricing in that marketplace.
    And since that marketplace is where home mortgages and car loans and credit card receivables are securitized, when you adversely affect the pricing in that market, it will raise the cost of borrowing in that market, which then gets down to the consumer level.
    So I am not going to say the sky is going to fall out of the sky. But pure market logic would have it that if you inhibit their ability to participate and you inhibit liquidity, you change pricing and you increase the cost of capital, which affects consumers.
    So that will happen. And that is why we are here today. And we appreciate the opportunity.
    Chairman BACHUS. Yeah, thank you. Well, that would not only maybe drive up the loans, it would also—would it affect the amount of funds available to make loans?
    Mr. GREEN. Absolutely because one of the principal purposes of the securitization marketplace is to ensure that on financial institutions' balance sheets are not loans that are just stagnant. And they can get rid of those loans on their balance sheet and get fresh capital.
    They can also, in a very sophisticated way, manage their risks and match their assets with their liabilities much better. So by inhibiting their ability to participate in that marketplace, it will in fact lower the supply of lendable capital.
    Chairman BACHUS. And that would, I think, affect your lower and middle income families probably disproportionately.
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    Mr. GREEN. Certainly, as any consumer who needs a car or a house or a refinanced mortgage or a credit card, yes.
    Chairman BACHUS. Okay. Thank you.
    Ms. Thomas, do you recall the original question?
    Ms. THOMAS. Yes, I do.
    Chairman BACHUS. Would you like to respond?
    Ms. THOMAS. Certainly. ICBA has had a number of opportunities and a variety of opportunities to meet and talk with the regulators about Basel II. This has included a number of our banker members as well.
    We have met with individual agencies on an informal basis. We have met with all the agencies on an interagency basis together, as well. We have participated in the comment letter process regularly on this issue.
    And we know that the regulators' door is always open to us if we have any questions. If we need to be briefed, if we have any concerns we want to express, we know well that we can do that.
    The other thing I would like to mention is that ICBA was the only U.S. trade association that participated in a meeting with the Basel Committee itself in July 2001. The Committee convened a meeting of representatives of small and medium-sized banking institutions around the world to hear our concerns.
    So we had an unprecedented opportunity to speak directly to the Basel Committee itself. And it was there that the U.S. regulators first signaled their intention not to apply Basel II to community banks.
    And at that point, that was our major concern. We saw incredible increase in regulatory burden, if that were the case. Our concerns were certainly addressed there, as the agencies have announced that they do not intend to do that.
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    I think now one of the main issues that we see is the competitive impact. And I think you heard from the first panel that they intend to take a close look at that issue.
    And they have been looking at it. And they intend to look at it closely, moving forward, particularly in the ANPR process.
    Chairman BACHUS. And that is on small lending, mortgage lending and residential mortgage——
    Ms. THOMAS. For our bankers, we are concerned about those retail credits, which are defined as mortgages and other loans to individuals and small businesses.
    Chairman BACHUS. Okay. And even though the agreement does not specifically apply to you, it would wash over and could affect your competitiveness on that market?
    Ms. THOMAS. Yes. We see that the Basel II banks, they plan on using the changes in Basel II to more finely price their products and services. They want the ability to price according to economic, as opposed to regulatory capital, try to match the economic capital more to regulatory capital.
    Our concern is that smaller banks, not being subject to Basel II, are going to have higher capital requirements for those same loans and credits. And all other things being equal, a larger institution will be able to price something lower but still achieve the same return on capital as the smaller bank, which has to price it at a higher level.
    So we are concerned about the competitive impact there. Some of the larger community banks that are publicly traded, they compete in the capital markets for capital. And they need to realize certain returns on equity in order to be competitive.
    And so we do see that as an issue. And one of the answers may be to make some additional adjustments for Basel I banks to address those inequities.
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    Chairman BACHUS. Have you suggested any change in Basel II to address your concern about these business lines?
    Ms. THOMAS. Not so much in the Basel II. I think we think that it will be more appropriate to make an adjustment for the Basel I banks.
    Chairman BACHUS. All right. Thank you.
    Ms. Maloney?
    Mrs. MALONEY. Thank you very much. My biggest concern with Basel II is the impact on the competitiveness of the U.S. financial services industry. And I understand some banks support it and some have questions.
    But as a whole, I think this competitiveness issue is the most important to address before the accord is implemented. And I want to be clear that I am not looking for an American advantage. I just want to make sure that our industry does not face a disadvantage.
    With this as a priority, I worked with the Chairman to introduce H.R. 2043. And one of the primary aspects of the bill establishes an interagency Committee, made up of the Treasury Secretary, the Federal Reserve, OCC and FDIC, to develop a uniform position on issues before the accord, before Basel II.
    If the members of the interagency Committee could not agree on apposition, the position of the Secretary of the Treasury would be the determinative position. It also requires a report to Congress before a decision is made; not that we could stop any decision, but at least we would be informed of what it is.
    And I was particularly concerned about not having any concrete evidence on the fact that our financial institutions were not disadvantaged. I would like to ask any of the panelists if they would like to comment on the legislation, if you think it is necessary or not.
    Mr. ELLIOTT. One place where this may be into the competitiveness issue that you are referring to is that Basel II, as designed, really is only on the banking institution component of financial services. There are many parts of financial services here in the U.S., as well as globally, that Basel II would not apply to.
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    And an institution like Mellon that I am associated with, many of our competitors are non-bank financial institution competitors. And here is where we feel the real inequality of the proposal.
    Our hope would be that, from a regulatory perspective, the regulators would be able to come to an agreement that would not penalize the banking sector, if you will, of financial services and that hopefully legislation would not be required.
    But having said that, at the same time, we are looking very much in terms of how competitive we can be. If our capital is higher, that means our return on equity is lower. That means our stock to investors is not viewed as attractively.
    And our ability then to access the capital markets to, in essence, grow the institution, is in essence hindered. In many ways, many of these risks we have been talking about, earnings, current earnings basically cover all of the risks. And we think that is a part of the dimension that they really have not addressed.
    Mrs. MALONEY. Well, Mr. Elliott, just following up on it, we had quite a discussion earlier with the regulators. And they seem to be in agreement now on the Pillar 1 approach to operational risk.
    And I want to know, on a daily basis, what do you do to manage operational risk? And how will a Pillar 1 approach lead to greater transparency? Or will it not?
    Could you—if you heard that earlier comment on operational risk.
    Mr. ELLIOTT. Yes, I did. Obviously, risk management for any financial institution has to be a core competency at the end of the day. And if you were to look in terms of not only the human capital that we put against it—you know the human intellect—as well as our internal systems, this is something that we are constantly enhancing and spending a great deal of money on, on a current basis.
    And we do not feel an explicit capital charge is going to enhance that process. In fact, if you think about it, it is really paying for it twice. You are paying for it in capital. And you are paying for it through earnings by having a very robust risk management system.
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    So our view would be that disclosure, which is part of the Pillar 3, which we really have not talked about a whole lot today. This transparency issue, we think, is very important. We are very willing. And we think frankly that most financial institutions are leaders in transparency.
    The tradeoff in transparency is if you have too much, in essence, there is too much overload possibilities of all your disclosures. So they do have to be focused. They do have to be on the relevant things.
    Obviously, from a regulatory perspective, the regulators have access to all of our internal systems, all of our internal ways of looking at risk, be it either operational risk or interest rate or liquidity. And our view is that the strength of the regulatory system basically is the way that you address this, as opposed to a capital charge that is difficult, if not impossible, to calculate and then compare from institution to institution.
    Mrs. MALONEY. Thank you.
    Would Mr. Green like to comment on the legislation?
    Mr. GREEN. Congresswoman Maloney, while we appreciate the spirit with which the legislation was introduced, we do not have a formal position on it. I would just comment, and again, from our relatively narrow markets' perspective, but I would just comment, thinking about the last 2 days. I testified at the Senate hearing yesterday.
    And the combination of these two hearings has probably done a great deal to achieve the underlying purpose, and that is developing a dialogue with the regulators, sending a signal to the regulators, allowing those affected by Basel II to have a forum to speak and have the regulators and legislators hear that. And I think we are all coming from these hearings with a clearer direction of what needs to happen between the Third Consultative Paper, the final Basel Accord and then the ultimate national implementation of it.
    So we applaud what you have done to this date. And for that reason, in our narrow market's perspective, we do not have a position on the legislation.
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    Mrs. MALONEY. Would anyone else like to comment? And the Chairman has informed me that we need to get ready for the next hearing.
    They gave us additional time on this incredibly important issue. And I thank the Chairman.
    If anyone else would like to comment, fine.
    Chairman BACHUS. Thank you. I would make just one final comment.
    Dr. Gup, I notice that you mentioned that some of our banks that do not participate in Basel II could be competitively disadvantaged. And Ms. Thomas, I think you have some of the same concerns.
    And I did note—and I do not know whether it was in the Senate testimony or in the submitted testimony today—that Director Gilleran, actually one of the concerns he expressed is that this may result in a wave of acquisitions, which is obviously a concern.
    That could even happen to a larger institution that was maybe, like Mellon Bank, that your business model was such that it caused you to be non-competitive. And you might actually, you know, your one alternative would be to be acquired, I would think. I am not sure that would happen.
    The other thing I would say, Mr. Elliott, the Federal Reserve or the regulators have never expressed any concern over how you address operational risk today, I would not think. Have they? Not to a great extent.
    Mr. ELLIOTT. Mr. Chairman, I am not sure I understand your question.
    Chairman BACHUS. Okay, have you—maybe I will ask another way. Have you ever had a problem or a concern with your management of operational risk? Or have they ever had a problem or concern?
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    Mr. ELLIOTT. With respect to our organization, no, they have had no concerns as to either our management of operational risk or how we would invest in the risk process. We get very high scores with respect to how we manage that aspect of our business.
    Chairman BACHUS. Right. And yet, under this agreement, they would substitute basically, with a complex and costly formula, for how you presently manage that risk.
    Mr. ELLIOTT. And part of the costliness would be adding a capital charge to our organization that, in essence, we would have to pass on to our customers or, in essence, be uncompetitive against our competition that would not have such a charge.
    Chairman BACHUS. Certainly, the description that this will simply bring some of our larger banks in is simply a reflection of what they are already doing. That is certainly not the case with Mellon.
    Mr. ELLIOTT. That is correct, yes.
    Chairman BACHUS. Thank you.
    If there are no further questions, I thank the second panel for your testimony. And you are discharged at this time. Thank you.
    [Whereupon, at 2:35 p.m., the Subcommittee was adjourned.]