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Tuesday, June 22, 2004
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 10:10 a.m., in Room 2128, Rayburn House Office Building, Hon. Spencer Bachus [chairman of the subcommittee] presiding.
    Present: Representatives Bachus, Gillmor, Biggert, Feeney, Hensarling, Garrett, Murphy, Maloney, Moore, Lucas of Kentucy and Frank (ex officio).
    Chairman BACHUS. [Presiding.] Good morning. Call to order the Subcommittee on Financial Institutions.
    At the end of this week, financial regulators from around the world will release the newly negotiated Basel Capital Accord, or Basel II. This accord has been heavily negotiated over the past several years, and there has been significant progress along the way. However, it is the view of this committee there are still several critical changes that should be made before U.S. financial regulators adopt Basel II.
    Today, we will hold a hearing entitled, ''The Basel Accord, Private Sector Perspectives.'' This is the third hearing that the committee has held on the new accord. Prior hearings highlighted disagreements among the Federal financial regulators and led the subcommittee to the markup of H.R. 2043, the United States Financial Policy Committee for Fair Capital Standards Act, legislation which would mandate development of a unified United States position prior to negotiating at the Bank for International Settlements.
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    Following subcommittee approval of H.R. 2043 by a vote of 42 to zero, we have witnessed more cooperation among the regulators and increased sensitivity to the opinions and perspectives of all the stakeholders in the negotiations. I hope this cooperation continues and that the Federal regulators work together in the best interest of the United States banking sector, financial industry and the U.S. economy as a whole.
    There is broad agreement that the first Basel Accord needed improvement. The global financial banking system has changed significantly since Basel, and the old ways of measuring and managing risk are simply inefficient. What has developed through the Basel II process is state-of-the-art risk assessment and management. However, there are significant issues that still need to be addressed before the United States endorses Basel II.
    The leadership of the Financial Services Committee submitted a comment letter to the financial regulators raising several concerns with Basel II and the related ANRP. Concerns related to operational risk, the risk weight for commercial real estate loans and the impact this accord will have on competition in consolidation within the financial sector were all issues raised by this committee, and none have been adequately addressed to date, in my opinion.
    Under Basel II, banks will be required to take a new mandatory capital charge for operational risk. The new charge will require banks to hold capital against losses resulting from inadequate or failed internal processes, people and systems, or from external events. This definition includes losses resulting from failure to comply with the laws as well as prudent ethical standards and contractual obligations as well as litigation risk.
    I have heard from several financial institutions that there is no widely accepted way to measure these losses and that efforts to quantify operational risk losses are in the very early stages. I would recommend that the Basel Committee seriously consider not making operational risk charge a mandatory one but rather one that is set on a case-by-case basis by the regulator. Because operational risk is so difficult to define, it makes sense for the regulator to know it when they see it and then set a capital charge as opposed to mandating the charge.
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    The Federal regulators often claim that the Basel II proposal will continue to evolve and be flexible. If that is true, the case should be an operational risk charge evolved from Pillar 2 treatment to Pillar 1 treatment once it has become easier to measure.
    The U.S. commercial real estate market has proven to be strong and is a key drive to our economy. Again, the committee is concerned that, as drafted, Basel II will require a 25 percent risk weight increase for some acquisition development and construction loans. This is highly problematic as it will drive banks out of this type lending, stifling economic growth.
    There have been tremendous advances in the assessment of risk for this type of lending. Unfortunately, the Basel Committee is not taking into consideration these important advancements and is applying an unsophisticated standard for the risk associated with this important lending sector.
    I am concerned that the real goal here is to improve risk management in Europe, Asia and other parts of the world. However, U.S. lenders will be negatively impacted even though they follow state-of-the-art management techniques in acquisition, development and construction lending.
    Competition in markets is key to ensuring that innovation is encouraged, services are available and prices are kept low. The Basel II Accord is going to apply only to the largest financial institutions in the United States. However, there are some institutions that will see compliance as a requirement to remain competitive while others simply will not have the resources or expertise to comply with Basel II.
    My concern is that this two-tiered system will, through regulation, force banks to merge, sell or change their business models. This can mean a reduction in access to financial products and to some increasing costs for consumers, all because of a regulatory regime that was negotiated outside the political process.
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    Basel II has the potential to radically change the way banking is done in the United States. I understand that the Federal Reserve has issued a white paper on this subject; however, it is my understanding that that white paper looks back at the effect of previous regulatory decisions on industrial consolidation—or industry consolidation, not forward. The fact is that none of the regulators actually knows what effect Basel II will have on the U.S. industry.
    I find it troubling that our regulators will be willing to consent to such an agreement before the conduct a fourth impact study, which is scheduled for this fall. Why not get the results of this study before agreeing to Basel II? What is the rush? If we are going to radically change the way banks assess their capital, shouldn't we look at what the impact will be on those institutions before signing on the dotted line?
    I want to thank the witnesses for appearing today. We have a diverse panel. I look forward to hearing your perspectives on the Basel II Accord.
    At this time, I will recognize Ms. Maloney for any opening statement.
    Mrs. MALONEY. I want to thank the chairman, and I agree that this is one of the most important issues before this committee and that we should have the impact study before going forward.
    I, first, would like to defer to the chairman of the committee, Mr. Frank.
    Mr. FRANK. Well, I wish that that is in fact what you were doing, but you are——
    Mrs. MALONEY. Chairman for the Democrats.
    Mr. FRANK. Thank you. I think pretender to the chairmanship is probably the actual title at this point.
    Chairman BACHUS. I didn't see you down there. I apologize. I did recognize you now that I see you.
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    Mr. FRANK. I thank you, Mr. Chairman. I am very proud of the work this committee is doing on a bipartisan basis, and I thank the chairman of the subcommittee, the chairman of the full committee, the ranking member of the Subcommittee on Domestic and International Monetary Policy which is really one of the areas which this affects, although it is within the jurisdiction of the Subcommittee on Financial Institutions.
    When this whole process started, frankly, we were watching the Federal Reserve simply go forward and do what it wanted to do without a lot of input from anybody else, including the other bank regulators. And this committee and members of this committee were alerted to some problems by a wide range of people in the banking community, let's be clear. We had some of the large institutions that do custodial work who were worried about the operational risk. We have the small bankers who really now have reopened, fortunately, the whole Basel I question and the impact competitively of differential capital requirements.
    And we have also, I think, uncovered a floor on America's decision making, because these are very fundamental issues and they were being done not only without any congressional input but really without input from anybody outside the Fed, the way it had been structured. We found that the Controller of the Currency and the head of the FDIC and head of the OTS all felt that they had been somewhat marginalized in the process, and we now have a genuine process that is going forward, and I appreciate that.
    There is one flaw still there, or at least one problem, that makes me less reassured than I am told I should be. People have said, ''Well, don't worry because once Basel II is affirmed internationally, it still has to be implemented by each country's own laws.'' But with regard, certainly, to operational risk, that means the Fed, I assume. I think the entities that would be there would be the Federal reserves. So we know that the Federal Reserve won't simply go forward with it, and that is why it is important for us to focus on it.
    I must say that I think we should, once this is put aside, continue to look at the situation. We have a very unsatisfactory situation from the standpoint of good governance as to how America's position is formulated on these major international issues, and I thank the chairman for having moved that legislation, and I am certainly convinced that we should continue our interest in this even after this is resolved one way or the other specific of Basel II.
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    As to operational risk, I remain convinced that it is a mistake to go forward with it. I think it is a case of doing something that is easy and quantifiable because what really ought to be done looks harder; that is, the management approach is the one that ought to be taken, that this is almost a disconnect in my mind between imposing a capital charge and the risks we are dealing with here.
    And I say that when we are talking about capital reserves for loan losses, et cetera, we know what we are talking about. We know a certain percentage of loans are going to go bad, you can deal with that. Operational risk is of course a simple name for a whole host of complex factors—of fraud, of physical damage, et cetera—and it does not seem to me that the analogy works, that the fact that you can put a capital charge for economic losses which over time you can calculate predict, that that translates into a whole bundle of unrelated kinds of specific issues.
    It is also the case that the experience, it does not seem to me, that we have had argues for the need for this. We have not had significant problems here which couldn't be handled under the normal rules, and you clearly have the problem of competitive disadvantage, particularly since we are talking here, by definition, about international activities. It is Basel II recognizing the international nature of this. So I believe that the case fails, as I have seen it, for a capital charge for operational risk, and I am concerned about the negative implications—the negative effect that will have.
    I also want to hear more about the argument that was raised by various of the smaller banks and confirmed by the chairman of the Federal Deposit Insurance Corporation, Mr. Powell, about the competitive disadvantage. Now, maybe the view is that we won't have to worry about that in 10 years because there won't be any small banks. We read about Wachovia now, we have read about B of A, we have read about Bank One and JPMorgan Chase. I mean when I came here this used to be called the Committee on Banking, Financial and Urban Affairs. We have now changed it to Financial Services. If we were to take back the House, we might go back to the old rule, because unlike our colleagues, we don't think Urban Affairs is like a bad word, so we would put it back in the title. But if we did go back, depending on when, we might have to change it. Instead of it being the Committee on Banking, Financial and Urban Affairs, in a few years it might be the Committee on the Bank, Finance and Urban Affairs, because I am not sure there will be more than a couple.
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    But for as long as we do have small banks, they ought not to be at a competitive disadvantage. And, obviously, we believe there should continue to be small banks. They play a very important role. I will say I have had some good relations with the larger banks that have merged in my area. It has also been the case that when those merges have taken place, the small borrowers, the local retailers, the local home builders have said to me that they thought it was important that some local banks also be around, because they have found that this is their preference for dealing with them.
    So preserving the ability of the community banks, the local banks to perform their function is very important. It is not in competition with the others; they have different niches, it seems to me. But that issue also, I think, still is unresolved, and I am grateful to those who have brought it to our attention.
    So with that, Mr. Chairman, I appreciate your convening this hearing again, and I hope that we will get some understanding on the part of the executive branch, particularly people at the Federal Reserve, that it would be a mistake—let me say, finally, it would be a mistake for them to go ahead simply because they have the legal authority to do it in the face of a significant lack of consensus. That is not a good way to run regulatory affairs. You can't simply do that by fiat, and I think it is clear from this ongoing process we are not yet at the point of consensus that ought to precede a decision of this magnitude.
    Mrs. MALONEY. Thank you very much. In the interest of time, I would like to put my opening remarks in the record, but I would just like to note my appreciation of the bipartisan leadership on oversight on this important issue. And as we all know, the discussions are now reaching a very critical stage where key issues must be hammered out and not just at a theoretical level but at a nuts and bolts level of detail that will really determine how the new accord will affect the financial services sector in the United States.
    And because the new accord will affect financial institutions differently, depending on their size and portfolio, we have asked a large spectrum of banks and others to attend and provide their view today. And our goal must be to encourage a fair, competitive field for U.S. institutions in the global market so that our institutions are not disadvantaged in any way in requiring higher capital standards or so forth. But we are also very concerned that banks within the United States are not unfairly disadvantaged or that one bank is not unfairly advantaged over another because of the type or the size.
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    So we have asked each of you to address these points in your testimony and of course to offer any other points that you may have. As you may know, based on our concern on this important issue, Chairman Bachus as well as Mr. Oxley and Mr. Frank and myself, we have put forward and have introduced legislation requiring U.S. legislators to develop uniform positions in the negotiations and to report to Congress on any proposed recommendations of the Basel Committee before agreeing to it.
    Regrettably, our legislation did not pass, but I believe that our concern demonstrated—our legislation demonstrated our serious concern and played an important part in advancing the many hearings that we have had and the negotiations we have seen today.
    I join Ranking Member Frank and Chairman Bachus in really urging that the report at least be completed and reviewed by Congress before going forward and that no other consensus be reached before making any international agreements that will be binding on American institutions, on their safety and soundness, their ability to compete here and the foreign markets.
    So I look forward to the contributions of the committee today, of the witnesses today, and I thank them for being here.
    Chairman BACHUS. You are going to yield back the remainder of your time? Okay.
    At this time, I know that Ms. Biggert and Mr. Murphy are going to introduce two of our witnesses, but, Mrs. Biggert, do you have an opening statement?
    Mrs. BIGGERT. I don't.
    Chairman BACHUS. Mr. Murphy, Mr. Hensarling, any opening statements?
    Mr. Moore, do you have an opening statement?
    Mr. MOORE. No, I don't.
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    Chairman BACHUS. All right.
    Mr. Lucas? Okay.
    If there are no other opening statements, we will introduce our first panel, in fact our only panel. So you all could be our last panel too. Our first witness is Mr. Steven G. Elliott, and I am going to recognize Mr. Murphy, the gentleman from Pennsylvania, to introduce Mr. Elliott.
    Mr. MURPHY. Thank you, Mr. Chairman. Mr. Elliott is here by popular demand in a return engagement. He is senior vice chairman of Mellon Financial Corporation where he is responsible for the corporation's Asset Servicing, Human Resources and Investor Solutions. The corporation's Finance, Treasury, Technology, Corporate Operations and Real Estate and its Venture Capital Businesses also report to him.
    His travels have taken him around the country with various positions, everything from a degree from University of Houston and business administration from Northwestern, he is also worked with Crocker National Bank and Continental Illinois National Bank and First Interstate Bank of California, so I would say most of the States have probably seen his hand in his abilities.
    Mellon manages $3.6 trillion in assets under management, administration or custody, and so his skills and knowledge of these issues runs deep, and we are delighted to have him here.
    Thank you, Mr. Chairman.
    Chairman BACHUS. Thank you, Mr. Murphy.
    We welcome you, Mr. Elliott, to the committee.
    Our next witness is Adam Gilbert. Mr. Gilbert is managing director of JPMorgan Chase. He is currently the chief operation officer for the Credit Portfolio Group, which is mandated to actively manage the firm's retained risk resulting from failed loan commitments and counterparty exposures.
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    In addition, Mr. Gilbert leads firm-wide efforts on various public policy and industry issues, including revision of the Basel Capital Accord and advises business and corporate functions on supervisory and regulatory matters. He was a member of the Corporate Treasury Group where he oversaw the development of economic capital and transfer pricing policies and supported the firm's Capital Committee.
    He began his career in 1987 at the Federal Reserve Bank of New York where for over 10 years he held positions in the Bank Supervisory Group, Credit and Discount Department and Research and Market Analysis Group. Interestingly enough, among other things, he spent two and a half years in Basel, Switzerland as a member of the secretariat of the Basel Committee on Banking Supervision.
    He graduated a Master's degree from Harvard University's John F. Kennedy School of Government and Bachelor of Arts from Tufts University where he graduated Summa Cum Laude and Phi Beta Kappa. Is that a fraternity, Summa Cum Laude? No. All right.
    I hope you all know I am kidding.
    When I campaign in some counties I say that is a fraternity.
    Our next witness—we welcome you, Mr. Gilbert. Our next witness is Joseph Dewhirst—Dewhirst, I am sorry. And Mr. Dewhirst is corporate treasurer at Bank of America. He is a member of the Management Operation Committee and Assets Liability Committee. He is responsible for managing corporate and bank liquidity and capital positions. He is also responsible for managing corporate insurance, economics and certain aspects of the management of corporate pensions and 401(k) accounts.
    He joined Bank of America as corporate treasurer just, what, two months ago? Coming from Fleet Boston Financial where he had been corporate treasurer. So you were merged into the Bank of America.
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    Mr. DEWHIRST. That is right.
    Chairman BACHUS. And he graduated also Harvard University—I mean Harvard College, Harvard University in 1973 where he majored in psychology and social relations, earned a doctorate in social psychology from Harvard University in 1978. For the past 16 years, Mr. Dewhirst has coached youth soccer in Sharon, Massachusetts and served on the Board of the Sharon Soccer Association. For two years, he served as president of the association. I appreciate that.
    Our next witness is Ms. Kathleen Marinangel, and I am going to recognize Ms. Biggert from Illinois to introduce Ms. Marinangel.
    Mrs. BIGGERT. Thank you very much, Mr. Chairman. I am very happy to welcome Kathleen Marinangel to the panel today. There is an old adage that, ''Ask a busy person to do the job, and they get the job done.'' I think this certainly applies to Ms. Marinangel. She is not only the CEO and president of McHenry Savings Bank but also the chairman of the board of directors, and she serves on the board of the American Community Bankers, which she is representing today and serves on the Basel II Working Group Committee, along with many other committees.
    She also is on the board of directors of the Illinois League of Financial Institutions, Thrift Association's Advisory Council, board of the directors of the Federal Home Loan Bank of Chicago, Illinois Board of Savings Institutions where she was appointed by the governor and serves to the president, American Council of State Savings Supervisors, along with another list.
    She also has her pilot's license and community involvement at Suntraga Board of Governors, City of McHenry Economic Development Commission, McHenry Area Chamber of Commerce, along with many others. I would like to welcome her here today.
    Chairman BACHUS. Thank you very much. Our next witness is—and welcome you, Ms. Marinangel to the committee.
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    Our next witness is Ms. Sandra Jansky, SunTrust Banks. She is executive vice president and chief credit officer. In this role, she oversees the company's credit-related functions, including credit policy, credit administration, credit and capital market risk, special assets, credit review, credit risk portfolio metrics and wholesale bank credit services. She has extensive commercial banking experience, including corporate and investment banking.
    She began her career at First Union National Bank, served there until 1981 when she joined SunTrust. She attended the University of North Carolina, graduated from the Louisiana State University Banking School of the South. She serves as executive committee member of the International Board of Risk Management Association and is immediate past chair. She is former chairman and board member of the Foundation for the Orange Public Schools in Orlando, Florida as well as various other civic organizations. So we appreciate your service on behalf of public schools there in Orlando, Florida and welcome you to the committee.
    Our final witness is Michael Alix. Mr. Alix is with Bear Stearns. He currently chairs the Security Industry Association's Risk Management Committee, and he will be testifying on behalf of Security Industry Association. He is senior manager and director and head of Bear Stearns Global Credit Organization. As such, he is responsible for overseeing independent counterparty credit risk management with focus on the firm's global fixed income and equity businesses. He chairs the firm's Credit Policy Committee and serves on its Risk, Operations and Principal Activities Committees. He is also active in the Bond Marketing Association.
    Prior to joining Bear Stearns, he held a variety of credit risk management positions at Merrill Lynch, including a Tokyo-based head of Asia Credit. Holds a B.A. in economics from Duke University and an MBA in Finance from the Wharton School of the University of Pennsylvania. We welcome you, Mr. Alix, to the committee.
    With the introduction of all the first panel, we will proceed to opening statements. We are going to start with Mr. Elliott and proceed through to Mr. Alix.
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    So at this time, I will recognize you, Mr. Elliott, for an opening statement.
    Mr. ELLIOTT. Thank you, Mr. Chairman. My name is Steve Elliott, and I am senior vice chairman of Mellon Financial Corporation, a leading global provider of financial services that has been serving its customers for more than 130 years. Headquartered in Pittsburgh, we are a specialized financial institution, providing institutional asset management, mutual funds, private wealth management, asset servicing, human resources and investor solutions and treasury payment services. Mellon has approximately $3.6 trillion in assets in our management, administration or custody, including more than $675 billion under management.
    It is a pleasure to testify today before the subcommittee on the potential impact of Basel II on Mellon Financial Corporation and, more broadly, on the ability of U.S. banks to serve their customers and investors. It was an honor also to appear last June before this panel on this topic.
    I am grateful for Congress' continued interest in the Basel Accord. Your focus on this sometimes overwhelming technical rule has ensured attention by regulators at home and abroad on what the changes to the international risk-based capital rules mean on the most important level: The ability of individual and corporate customers to get what they need at a competitive price from a vibrant U.S. financial services industry.
    As a specialized financial institution serving pension plans and the securities industry, Mellon has a special concern with a particular aspect of the Basel II proposal: The new regulatory capital charge for operational risk. We think much in the proposed new international capital standards and low regulations plan to implement them are quite good. Indeed, the current risk-based capital standards need wholesale rewrite. However, the overall need for new capital standards should not distract from the critical importance of getting the details right.
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    The operational risk charge could well have a dramatic and adverse competitive impact on specialized banks. Trillion dollar diversified banks can offer a broader range of services to their customers; however, that is often done at a cost: The inability to focus clearly on individual clients who want a high degree of expertise and service in areas like asset management and payment processing.
    Mellon is grateful to you, Chairman Bachus, and the leadership of this subcommittee, along with that of the Financial Services Committee under Chairman Oxley and Ranking Member Frank, for your continued attention to the many problems with the operational risk charge, particularly its potential adverse competitive impact.
    You have rightly pressed the Federal Reserve to analyze the Accord's competitive impact. We understand the board is currently studying the operational risk-based capital charges competitive impact. Mellon is of course happy to cooperate in any way that would help in bringing about the right result.
    The board has completed a study on the rule's impact on mergers and acquisitions—a key question to ensure that the Nation's banking system does not become too consolidated. I would argue that there is a direct correlation between capital and business activity, that if there wasn't, it would be hard to understand why all of the U.S. and international banking agencies have devoted so many years of hard work to the Basel II rewrite. This is far from a technical exercise but rather one of profound implications.
    Today, I would like to emphasize the need for the Basel rules and, especially the U.S. version, to rely upon effective prudential regulation and enforcement to address operational risk. An arbitrary regulatory capital charge for operational risk, like the one now proposed, will have an adverse market consequences that will ultimately undermine our customer service.
    The risk posed by the operational risk capital charge, even in the advanced version proposed in the U.S. We continue to believe that the ongoing improvements to operational risk management will be undermined by the proposed capital charge, creating perverse incentives for increased operational risk, not the decrease that regulators desire and on which Congress should insist.
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    And the importance of other changes to the U.S. version of Basel II to ensure that our banks remain competitive and focused on key market needs. This means a review of the complex credit risk standards for specialized banks. A hard look at the proposed retention of a leverage standard and the criteria for determining who is a well-capitalized bank is also vital, since these standards only govern U. S. banks and could have an adverse competitive impact if retained.
    Mellon respects the desire of the Federal regulatory agencies in Basel and the U.S. to advance operational risk management. That is why the Financial Guardian Group, to which Mellon belongs, has answered the U.S. regulators' request for a detailed and enforceable safety-and-soundness standard with a comprehensive proposal. I have attached that proposal to this statement for your consideration.
    The U.S. regulators also have asked us for a safety-and-soundness approach, called Pillar 2 in the Basel framework, to be paired with an improved disclosure, Pillar 3, to back up regulatory enforcement with market discipline. We took that request very seriously and provided a detailed proposal which I have also attached to my statement. The Federal Reserve Board thanked us for our submission but does not appear to be pursuing it as an option. However, we are still hopeful that a compromise can be reached.
    Thank you, and I will be pleased to answer any of your questions.
    [The prepared statement of Steven G. Elliott can be found on page 69 in the appendix.]
    Chairman BACHUS. Thank you.
    Mr. Gilbert?
    Mr. GILBERT. Good morning, Chairman Bachus, Congressman Sanders and members of the subcommittee. My name is Adam Gilbert, managing director in the Credit Portfolio Group at JPMorgan Chase & Co. JPMorgan Chase is a U.S.-based internationally active bank operating in more than 50 countries. We are currently in the process of merging with Bank One, the Nation's sixth-largest bank holding company. Thank you for inviting me here to discuss the proposed revisions to the 1988 Basel Capital Accord, more commonly referred to as Basel II.
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    We commend the committee's continued interest in Basel, which has been beneficial to the process and appreciate the unique opportunity to have a constructive dialogue concerning what we expect will be an improved framework for regulatory capital requirements. We also commend the Basel Committee, the US regulators and U.S. financial institutions for the openness of the process and their role in developing the proposals.
    Although there are a number of areas requiring further consideration, the proposals to date do a far better job of measuring risk than the rules they are intended to replace. Please allow me to begin with a summary of our views and conclude with areas we suggest warrant further review.
    We strongly support the direction of Basel II. The three pillars of minimum capital requirements, Pillar 1, supervisory review of capital adequacy, Pillar 2, and market discipline, Pillar 3, provide a solid framework in which to address safety and soundness issues in an environment of continuous innovation in the financial markets.
    The committee's objectives with respect to Pillar 1 capital requirements, that is improving the way regulatory capital requirements reflect the underlying risks and incorporating advances in credit and operational risk measurement techniques, will address deficiencies related to the current regime and have the potential to promote stronger practices at internationally active banks. Today's capital rules treat all borrowers the same regardless of credit quality and do not address operational risk explicitly. Basel II will correct this.
    Ultimately, a bank's risk profile is best measured using its full range of internal models. As an important step in that direction, we welcome the advanced internal ratings approach, which will permit banks to incorporate their own estimates of default and loss recovery rates into a formula calibrated by supervisors. We also welcome the advanced measurement approach for operational risk which directly leverages banks' risk measurement techniques.
    There has been considerable debate about the appropriateness of a Pillar 1 capital charge for operational risk. We are highly supportive of a Pillar 1 approach rather than a Pillar 2 approach, as some have suggested. A Pillar 2 approach would require banks to gather essentially the same information as if they had a Pillar 1 charge, yet there likely would be a loss of transparency and consistency in the methodology applied across the global industry.
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    For about a year now, we have had an internal operational risk capital charge in place which we believe is consistent with the AMA standards. We have this charge because we are fully cognizant that inadequate or failed systems, processes or people can result in losses to our firm. The information and control processes associated with our capital framework have already provided significant value to our business and risk managers.
    The science around operational risk measurement will continue to evolve, no doubt, but we believe that an explicit Pillar 1 charge and associated standards will be beneficial in this regard and will promote further discipline in banks' operations.
    In a few days, the Basel Committee will release a revised version of its capital accord, reflecting comments from across the financial services industry. The new version of Basel II will incorporate positive changes related to the calibration of the overall capital requirement, the measurement of credit risk for wholesale and consumer businesses as well as guidance on the practical application of the AMA.
    We appreciate the fact that the Basel Committee has committed to continue work on several important areas that we believe necessitate further enhancements. These areas include the treatment of counterparty credit risk, hedges of credit risk and short-term exposures. There are several other issues which merit clarification and modification, but these are largely technical in nature. Additional information can be found in our recent comment letters or I would be happy to discuss these in greater detail during the Q&A.
    To be sure, there is a lot for both banks and supervisors to do to prepare for the implementation of Basel II. A primary example is the qualifying process for the advanced approaches, which will be very burdensome unless there is close cooperation among supervisors. Home countries' supervisors must play the lead role to ensure that the process for qualifying is addressed at the consolidated level and that banks do not have to go through separate approval processes in every country in which they have a presence.
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    We understand that some local requirements might be different for subsidiaries and possibly branches, but we expect the home supervisor to help bridge the gaps when necessary. We are confident the U.S. supervisors will do just that.
    Chairman, I would like to thank you and the committee for the opportunity to speak on these issues. This concludes my remarks today, and I would be happy to answer any questions you might have.
    [The prepared statement of Adam M. Gilbert can be found on page 78 in the appendix.]
    Chairman BACHUS. Thank you, Mr. Gilbert. And before I recognize Mr. Dewhirst, I did want to say that, without objection, your entire written statements will be made a part of the record.
    At this time, Mr. Dewhirst, you are recognized for an opening statement.
    Mr. DEWHIRST. Chairman Bachus, members of the Subcommittee, on behalf of Bank of America, I would like to thank you for this opportunity to provide our comments regarding the Basel II framework. I am Joseph Dewhirst, and I am the corporate treasurer of Bank of America.
    Let me begin by summarizing Bank of America's position on Basel II. First, the overriding concern of bank regulators is the safety and soundness of the banking industry, and, of course, we share this concern. Capital is a buffer against loss, and it seems sensible to us that bank management and bank regulators assess the adequacy of bank capital by looking at risk of loss.
    Bank regulators worldwide used Basel I to formalize the view that capital allocation should be risk-based. This capital accord was, in our view, a major step forward in rationalizing the assessment of the capital adequacy of banks. But Basel I was, nevertheless, only an initial step.
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    As the industry has developed more sophisticated methods for measuring risk, often dependent on computing power that has become available only during the last decade, there has been a growing need for more advanced regulatory capital requirements, and Basel II is that more advanced approach. So we strongly support the Basel initiative to better align regulatory capital requirements with underlying economic risks.
    Next, let me give a brief assessment of the progress made. Our general view is very positive. Significant progress has been made, and we commend the agency's leadership in this process. While time-consuming and sometimes contentious, the consultative dialogue maintained with the industry has improved the transparency of the process and the quality of the results.
    There are, nevertheless, several technical issues that still cause us concern, and we summarized some of these issues in a technical appendix; but we have every confidence that these issues will be resolved before the final implementation date.
    Some have raised questions about operational risk. Bank of America strongly supports the Pillar 1 capital requirements for operational risk, because it aligns the regulatory capital requirements with industry best practice. Recent history provides ample evidence that operational risk can be significant, and it deserves the same rigor of analysis that is employed for credit and market risk.
    Bank of America has already implemented explicit capital charges for operational risk within its own internal systems. We believe these models are almost fully compliant with the AMA requirements, and it would be disingenuous for us to take any position other than supporting the Pillar 1 approach.
    Let me turn next to the competitive environment. We believe that changes in capital requirements will not materially alter the competitive landscape. In particular, well-managed banks will not see significant change. To the extent that change does occur, it will follow from more prudent management of risk and more rational allocation of capital.
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    Bank of America believes that good risk management provides a competitive advantage, irrespective of the regulatory capital framework. Therefore, we have invested significant time and resources to develop industry leading risk management processes and economic capital models.
    Correspondingly, Bank of America already manages its business activities on the basis of risk-based capital. We believe that these tools enable us to make better risk and return decisions. Since we already manage based on methods broadly consistent with Basel II, our behavior is not likely to change in any material way.
    Concerns have been raised regarding the prospects for industry consolidation as a result of Basel II. Of course, there are economies of scale in risk management. So at the margin, by encouraging good risk management, Basel II may encourage consolidation. But it will be insignificant compared to other drivers of consolidation, such as the economies of scale around product development, systems and staffing as well as the benefits of diversification across business and geography.
    As indicated, we have a number of technical concerns. Under Pillar I, work remains to be done on a calibration of capital for mortgages and other retail assets. The current approach assumes that there is inherently more risk in these assets than seems justified. Under Pillar 2, we have concerns about implementation of rules to create a level playing field internationally. And under Pillar 3, we think that the disclosure requirements of the standard are still excessive.
    As I said, we provide details regarding these and other concerns in the attached appendix, and I would be happy to answer questions.
    In closing, let me again assure you that we strongly support the objectives of Basel II, and we have been pleased both with the process and progress to date. While we acknowledge and recognize outstanding issues, we believe these issues can be resolved satisfactorily. Finally, we believe that Basel II will encourage better management of risk and more rational allocation of capital within the banking industry. Thank you.
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    [The prepared statement of Joseph Dewhirst can be found on page 60 in the appendix.]
    Chairman BACHUS. Thank you, Mr. Dewhirst.
    Ms. Marinangel?
    Ms. MARINANGEL. Mr. Chairman, Ranking Member Sanders, and members of the subcommittee, my name is Kathy Marinangel. I am chairman, president and chief executive officer of McHenry Savings Bank, a $210 million institution in McHenry, Illinois. I appear today on behalf of America's Community Bankers, where I serve as a member of the board. Thank you for this opportunity to testify on the impact that the Basel II Accord will have on community banks.
    I believe that the development and implementation of the Basel II Accord will present one of the most significant threats to community banks today, unless it is balanced by a carefully revised Basel I Accord.
    Since the adoption of the Basel I in 1988, the ability of all financial institutions to measure risk more accurately has improved exponentially. Community banks desire to adopt a more risk-based sensitive model, such as Basel II. Unfortunately, the complexity and cost of implementation of the Basel II models will preclude most community banks from taking advantage of the positive benefits.
    I think the resultant disparity that will be created between banks is totally wrong. Under the current proposal, my institution would remain subject to Basel I. If it were economically feasible, my bank would prefer to opt in to Basel II. In fact ACB believes that any financial institution that has the resources should be able to opt in to Basel II.
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    While there are a number or risks involved in determining risk-based capital, an important one is interest rate risk, which Basel I has generally failed to address for most community banks. After barely surviving the high interest rate cycle of the late 1970s and early 1980s, McHenry Savings Bank adopted a strategic plan that included a goal to diversify assets in such a way that the bank would never again rely on one type of asset in its loan portfolio so that we could better manage interest rate risk.
    An important factor in this strategy was the ability to reprice as many assets as often as possible. We believe that flexibility and repricing is a key to survival in times of fluctuating interest rates. For several years, McHenry Savings Bank has repriced 80 percent of its assets annually.
    Shortly after completing the restructuring of our portfolio, in 1988, Basel I was implemented. Unfortunately, the simplicity of the formula did not enable a determination of the true risk of assets. Little or no consideration was given to collateral value or loan to value of these assets. Thus, Basel I has forced us to give up an asset mix that would reprice frequently, something that we would want now in a rising rate interest rate cycle. New options under Basel I are essential.
    ACB supports the efforts of U.S. and global bank supervisors to more closely link minimum capital requirements with an institution's true risk profile. This approach could improve the safety and soundness of the banking industry and allow institutions to deploy capital more efficiently. However, a bifurcated system will open the door to competitive inequities.
    Two banks, a larger Basel II bank and a small Basel I community bank, like mine, could review the same mortgage loan application that presents the same level of credit risk. However, the larger bank would have to hold significantly less capital than the small bank if it makes that loan, even though the loan would be no more or no less risky than if a community bank made that loan, assuming the large bank adopts Basel II.
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    Capital requirements should be a function of risks taken, and if two banks make similar loans, they should have a very similar required capital charge. ACB is concerned that unless Basel I is revised, smaller institutions will become takeover targets for institutions that can deploy capital more efficiently under Basel II. As community banks disappear, the customers will lose the kind of personalized service and local decision making they want.
    If Basel II is implemented for a portion of the banking industry, changes must be made at the same time to Basel I to maintain similar capital requirements for similar risk. For example, I have developed a formula in appendix A that includes more baskets and a breakdown of particular assets into multiple baskets when taking into consideration collateral values, loan-to-value ratios and other factors.
    Whatever refinements are made, community banks must retain the option to leverage their capital regardless of the complexity of the calculations. Community banks must be given the opportunity to compete against the international banking giants who, by the way, have branches in my town and many other towns across America.
    We thank Chairman Bachus and the rest of the subcommittee members for holding this hearing. As I mentioned at the outset, there is no more important issue to community banks today than the proper implementation of Basel II and the sensible revision of Basel I. Thank you.
    [The prepared statement of Kathleen Marinangel can be found on page 90 in the appendix.]
    Chairman BACHUS. Thank you, Ms. Marinangel.
    Ms. Jansky, I welcome your testimony.
    Ms. JANSKY. Mr. Chairman and members of the committee, I am very pleased to have the opportunity to discuss SunTrust's view of the proposed capital accord. I am Sandra Jansky, executive vice president and chief credit officer for the company.
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    SunTrust is the seventh largest domestic bank in the United States. We have 1,201 offices located in 11 states, with 27,000 employees.
    In my comments today, I will address our reasons for choosing to become an opt-in bank, that is voluntary compliance—I understand that has a different meaning in Washington—but is a volunteer bank, and also discuss the issues that we believe continue to be problematic.
    Our financial institution believes that it is imperative for us to comply with the provisions of Basel II. As a conservative risk taker, we believe we have been required to hold excessive regulatory capital without true consideration for the composition of the risk in our institution. If there is an opportunity to better align regulatory capital with economic capital, we want to be able to qualify for such treatment.
    We believe we have to move forward quickly to meet these requirements under the accord due to our current size. By the end of September 30 of this year, we will have approximately $145 billion in assets. Due to the complexity and the vast requirements recommended under the accord, it is impractical for our institution to delay compliance with the proposal. We believe delays would further add to the cost of implementation and cost of compliance.
    We also believe that we would be at a competitive disadvantage compared to the core banks if they are able to operate with lower capital levels than our institution. We have considered voluntary compliance because it has made our effort to try to work towards a better alignment more important to the institution. As an opt-in bank, we have issues in meeting the accord requirements, primarily because we are not at the table with the core banks and the regulators when key issues are explored and recommendations are made on a wide variety of issues.
    Core banks have the advantage of more focused regulatory assistance as they pursue the advanced internal ratings-based status. Volunteer banks need additional guidance and assistance from the regulators that frankly is not currently available.
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    I have outlined in our testimony some of the benefits that SunTrust has seen from beginning the implementation of the Basel II Accord, primarily our risk rating system. As much as we like certain aspects of the accord, we do believe the overly prescriptive requirements as well as the level of complexity will continue to challenge us as we move towards advanced internal ratings-based status.
    We continue to remain concerned about the special treatment provisions required for certain specialized lending areas, such as commercial real estate. While some change has been announced to the original proposal, we believe that the higher capital requirements for certain asset types without regard to the specific risk management practices of a particular institution or the performance of those assets over time is problematic.
    We are also concerned about the correlation requirements for residential real estate and home equity lines and loans versus credit card products that we understand are in the accord. The proposed treatment will impact the cost of credit availability to certain product lines that have grown tremendously over the last 10 years. The correlation requirements proposed could result in higher capital to secured equity products than unsecured credit card products. Our actual experience in these products over a significant period of time indicates the losses have been significantly below those minimum requirements.
    Of all the changes required for advanced status under Basel II, the most significant for us is the quantification of operational risk. The Federal Reserve has taken the position that the advance measurement approach is the only acceptable approach to calculating operational risk regulatory capital and is therefore required if a bank wants to use the advanced internal ratings-based approach to credit capital. We believe this might place certain banks in the American banking industry at a competitive disadvantage.
    If SunTrust can satisfy the requirements for the advanced internal ratings-based approach for credit risk and we fail to meet some of the unspecified requirements for the advanced measurement approach for operational risk, we will be forced to continue with the current accord. A similar bank in another country would have the ability to use the AIRB approach for credit risk and the basic or standardized approach for operational risk.
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    Finally, we have outlined some issues with the disclosure requirements in my testimony. Primarily, we believe they will add additional pages of information, highly technical, that will be of little value to a vast majority of the readers.
    SunTrust believes the new accord is a very positive step in the right direction. We would like to see the regulators establish a working group of the opt-in banks to further enhance our ability to meet the requirements under the accord. We also would request that the U.S. regulators consider allowing banks to qualify for the advanced internal ratings-based capital approach for credit risk, while considering the standardized or basic approach for an interim period of time. We also believe the asset correlations, as I mentioned earlier, need to be addressed.
    Thank you, Mr. Chairman.
    [The prepared statement of Sandra W. Jansky can be found on page 81 in the appendix.]
    Chairman BACHUS. Thank you, Ms. Jansky.
    Mr. Alix?
    Mr. ALIX. Thank you, Mr. Chairman and members of the subcommittee. I am Michael Alix, senior managing director of Bear Stearns and Company and global head of Credit Risk Management. I am also chairman of the Securities Industry Association's Risk Management Committee. I appreciate the opportunity to testify on behalf of a group of those members of SIA, including Bear Stearns, which are likely to be applicants under the Security and Exchange Commission's new regulatory regime for global consolidated supervision, otherwise known as CSE.
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    My testimony today comes from the somewhat new perspective of an investment bank viewing Basel II through the prism of the CSE framework. I wish to make the following points. First, in order for U.S. investment banks to compete on a level playing field in Europe, we need to know now If the EU deems the SEC program for consolidated supervision equivalent.
    Second, regulators must coordinate and cooperate with counterparts around the globe to ensure smooth implementation of Basel II to avoid excessive costs and duplication of effort that could impose undue burden on firms.
    Finally, in order to ensure competitive equality, both banking and securities regulators must address certain remaining technical issues with the risk-based capital calculations required under Basel II.
    Let me say a few words about how we got to this point. Major U.S. investment banks are likely to be subject to the Basel Accord, including its risk-based capital standards under the SEC's recently released consolidated supervision program. One key driver of CSE is the requirement by the European Union that firms operating in Europe are subject to comprehensive consolidated supervision. That is why we care about Basel.
    The day-to-day experience with Basel I and the leading role of their banking regulators was a key reason why commercial banks were involved closely in the development of Basel II. The major investment banks and securities supervisors were, by comparison, late to the table with respect to key policy discussions with the framers of Basel II.
    Initially, investment banks observed that the apparent Basel II capital requirements for some of their key businesses were out of line with perceived risk and actual loss experience. I can report that firms have made significant progress in the last year, clarifying how the calculations should be made and conveying important technical flaws in the accord through direct, constructive discussions with Basel Committee members.
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    Detailed technical discussions with officials of the Federal Reserve and the SEC enabled four large investment banks to refine their calculations and complete a quantitative impact study that informed our comments on the Federal Reserve Board's advanced notice of proposed rulemaking.
    The recent formation of a task force by the Basel Committee and global securities regulators to follow up on many of our concerns provides important evidence that the Basel Committee takes seriously the unique perspective of the investment banks.
    Now, for the remaining steps. First, and most importantly, it is essential that we obtain an EU determination that the CSE is equivalent. Originally, the guidance was to be announced by the end of April this year with the first set of equivalence judgments by June. These time tables have slipped, and we ask that you and your colleagues on the full committee monitor this situation carefully. It is our judgment that there should be no doubt that CSE is equivalent.
    Second, it is essential that all regulators coordinate and cooperate with their counterparts around the globe on implementing Basel II. Doing so will permit regulators to leverage their resources, help ensure that no entity is subject to duplicative or inconsistent requirements, and help ensure that supervisory responsibility is lodged with the regulator best situated to exercise such responsibility.
    Flexibility in the application of the Basel standards under CSE will be very important. U.S. securities firms have not been subject to Basel standards on a firm-wide basis and thus have not been obligated to build a global Basel I infrastructure. Since banks will have until as late as 2008 to implement the more advanced Basel II approaches, flexibility is necessary for CSE applicants to avoid the undue expense and burden of requiring implementation of a standard destined to be superseded in the near future. In other words, if you decided to build a new baseball stadium in the District in, say, two years, you should not have to pay to renovate RFK right now.
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    The collaborative process must continue for international capital standards to more fairly reflect the risks inherent in the investment banking business, without imposing large and unnecessary costs. Perhaps most significant among many still open items is whether the SEC and other global regulators will recognize the reality that much of our risk taking relates to trading, rather than banking, activities that meet both the spirit and the letter of the Basel Committee's definition of a trading book.
    Banks and securities firms operate and report under substantially different accounting frameworks. Banks generally carry risk assets at cost, accrue earnings, and establish formula reserves. In contrast, securities firms mark to market and treat virtually all business lines as part of a trading book. If in the application of Basel II to investment banks regulators require investment banks to compute capital requirements for trading activities as though they are part of a banking book, investment banks would be taking a double hit in the computation of their requirements.
    We very much appreciate the subcommittee's interest in the adoption and implementation of Basel II. We look forward to working with Congress, the administration and the regulators on finalizing and implementing a new capital accord. Thank you very much.
    [The prepared statement of Michael J. Alix can be found on page 46 in the appendix.]
    Chairman BACHUS. Thank you, Mr. Alix.
    At this time, I recognize Mrs. Biggert for any questions that you have for five minutes.
    Mrs. BIGGERT. Thank you very much, Mr. Chairman. This is a question I think that probably all of you could answer, because there seems to be a difference of opinion in what type of bank or institution you have. And that is what effect does the regulatory capital have on your pricing and lending decisions? And does the regulatory capital play a more important role in the management of a community bank than it does for a large financial institution?
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    I think I will start with Ms. Marinangel.
    Ms. MARINANGEL. The second part of the question was does the——
    Mrs. BIGGERT. Does regulatory capital play a more important role in the management of a community bank than it does for a large financial institution?
    Ms. MARINANGEL. I think the roles are similar. Currently, we are all under the same regulations, and the mix of the portfolio you have to live by the risk-based capital levels is the same to maintain a well-capitalized bank.
    Recently, for example, I have had to sell some very well-collateralized commercial loans off to some of my competitors. We have kind of coordinated in that. But to maintain the well-capitalized level, my opinion is that maintaining mortgage loans on your balance sheet, which are 50 percent weighted, now will cause—even though it is a good credit risk, will cause interest rate risk problems as interest rates rise. And, therefore, I feel that the formula has caused problems for a rising rates scenario, and I am sure it is similar for both community banks and the larger banks.
    Mrs. BIGGERT. Well, it is my understanding that at least in the areas of small business and mortgage lending, that the advanced approach of Basel II will likely result in significant reductions in the required capital. And if this assumption is correct, do you think that Basel II will make it more difficult for small banks to compete?
    Ms. MARINANGEL. Absolutely. I think that deploying capital more efficiently and leveraging capital which will result from the Basel II banks being able to opt in will cause community banks to not be able to compete as effectively. The pricing of the products, as you stated, when you utilize your capital more efficiently, you can price some products at a lower price for the consumer and make it up in other areas. And the larger banks, some of them, offer credit cards and other products that the community banks can't necessarily offer at an efficient level. Therefore, it will make it extremely difficult for us to compete if we are not able to opt in to Basel II or have a revised I.
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    Mrs. BIGGERT. Okay. And I believe that the banking regulators have recently announced they will consider revising Basel I?
    Ms. MARINANGEL. Yes. They have mentioned that they would take it under consideration, and there would be two approaches. Some community banks may not want to adopt the more advanced Basel I, so they could be left as is or my example that was attached shows more buckets are fairly easily administered, but there could be also a more risk-sensitive approach that is not as complex as the Basel II. And where additional risk for complex and sophisticated products could be added in, could be a Basel 1.5 and less complex.
    Mrs. BIGGERT. I think you have the alternative proposal in your testimony. Have you shared this with the banking regulators?
    Ms. MARINANGEL. Yes. I have sent thousands of letters over the years, but most recently in November, when the comment letter was due, I sent 1,000 letters out to those banks that had less than 11 percent risk-based capital as well as all the regulators. And I find that, for example, a mortgage loan, even if it has a 20 percent or 90 percent loan-to-value ratio, is in the same bucket, which makes no sense, and banks are not given credit for the differences in loan to values, durations or collateral. As another example, for the last 10 years in McHenry Savings Bank, my commercial real estate loans have had zero losses in 10 years. My overall loss has been less than one-tenth of 1 percent on my whole portfolio because I am a heavily collateralized lender, and I am not getting any credit for my asset risk in that regard.
    Mrs. BIGGERT. Thank you. I have just a short time left, so if anyone else would like to comment on this? No statements? Okay.
    Yes, yes, Mr. Dewhirst?
    Mr. DEWHIRST. In general, I would say that regulatory capital has no role or a de minimis role in pricing. The principles that are the basis for regulatory capital, the risk-based capital principles, do drive our pricing decisions, and that has been true for a long time. But we don't focus on the regulatory capital side of things in looking at those decisions.
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    As Basel II is implemented, what will happen is the methods of regulatory capital will become more in line with the pricing disciplines that we are using already.
    Now, to the general question of mortgages, I would tend to agree with the comments that risk in mortgage assets is overstated in Basel I. I would just make the observation that Basel II is moving in the right direction in reducing those risks, so to the extent that it is a more rational assessment of the risk in those assets, that should help. The problems that were mentioned about excessive risk weights for mortgages are problems in Basel I that we would all hope to correct.
    I don't really have a strong answer for whether regulatory capital plays a more important role in the management of a community bank. I know that we hold more capital at Bank of America than is required by the regulators by a long shot. So regulatory capital is not a constraining factor.
    Mrs. BIGGERT. Thank you. Thank you very much. My time has expired. Yield back.
    Chairman BACHUS. Thank you, Ms. Biggert.
    Mr. Frank?
    Mr. FRANK. Thank you, Mr. Chairman. I haven't had a chance to read the testimony, so I am upset at myself. I have a fundamental question, maybe I am missing something. Sometimes I find out when I ask fundamental questions I may not be the only one who is missing something. And that is I am trying to understand how it is that a capital charge is supposed to alleviate, diminish, compensate for operational risk. I understand a capital charge with regard to lending, and I know you are not, on the whole, all advocates of it, but I want to understand—I mean is it—there are a couple of possibilities.
    One is that a capital charge somehow will give you an incentive to avoid the dangers, I don't think anybody is really arguing that. Is it that the amount of capital you have to put aside, is that supposed to be able to take care of any losses in operational risk so that we don't have to go to the fund? What is the relationship? From their standpoint, as you understand it, how will requiring you to put up this amount of capital help us avoid the problems that would result from the operational risks becoming real problems? Yes?
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    Mr. GILBERT. Thank you, Congressman. One can never say that will help you avoid all problems. No capital charge could do that at a reasonable cost. I think the best way to think about an operational risk capital charge is in the context of an entire risk management framework. It is not an end in and of itself.
    Mr. FRANK. What contribution does it make to this? I mean I can't look at the whole thing. I need to know what is better because we have a capital charge for operational risk than if we didn't?
    Mr. GILBERT. Right. Because it makes the risk that we run in our operations much more transparent, so the measurement processes, the control processes that feed into the capital make it much more transparent.
    Mr. FRANK. You don't have to have a capital charge to make the risks transparent? Transparent to whom, I guess would be the first question.
    Mr. GILBERT. Well, it certainly makes it more transparent to our internal businesses and risk managers. It provides them incentives to control those risks——
    Mr. FRANK. How does it provide them an incentive to control the risks that they don't otherwise have? I mean would a capital charge go down if they——
    Mr. GILBERT. Yes. In a risk-sensitive regime, if they have stronger controlled mechanisms that are experienced——
    Mr. FRANK. And you mean the people running the operation don't have an incentive to reduce those anyway? I am really skeptical that a capital charge in terms of transparency internally. I mean, first of all, doing a lot of capital charges through management supervision would seem to do this, but your argument is that the capital charge increases the internal incentive to avoid the dangers and also makes people more aware of what they are? It would seem to me there are better ways to do that, and I would hope that they would be doing that without this.
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    Mr. GILBERT. They largely do, but the capital charge internally puts a highlight, a stamp on that, if you will, and helps make transparent what it costs to the organization of not——
    Mr. FRANK. Let me ask others what they think about either that particular justification or some others?
    Yes, sir?
    Mr. ELLIOTT. At Mellon, we take an entirely different viewpoint here. Where we have tried to focus our resources——
    Mr. FRANK. No, no. I am asking you—Okay, well, go ahead finish this if it is directly responsive.
    Mr. ELLIOTT. I think it will be, sir.
    Mr. FRANK. Okay.
    Mr. ELLIOTT. Where we have tried to focus our resources around the operational risk side of things is not on a capital charge, which really is in many ways a black box, especially to people on the inside. But it is really to focus in terms of the basic fundamentals of risk management, starting all the way at our board of directors——
    Mr. FRANK. I understand, sir. Let me ask you this: Would a capital charge give you any greater incentive, do you believe, to deal with risk?
    Mr. ELLIOTT. Not in our view, no.
    Mr. FRANK. Yes. I mean I would think you would have—I mean what are the operational risks? Are you talking about theft, about fire, about——
    Mr. ELLIOTT. The more relevant ones, typically, on the part of financial services that we deal with, which is more the processing and asset management businesses, are errors in pricing, there are errors like in not doing a corporate action, recognizing a merger or an acquisition type of transaction, and they are typically very modest in proportion if you——
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    Mr. FRANK. Okay. But, again, I don't see—it does seem to me you have every incentive to avoid those anyway, so I don't see what a capital charge—what about transparency? Would a capital charge increase transparency in your operation?
    Mr. ELLIOTT. No, sir, not the way we look at it. We would see it in terms of basically having those strong internal risk management systems is where your first line of defense——
    Mr. FRANK. Let me ask if any of the others have any—yes, Mr. Dewhirst?
    Mr. DEWHIRST. You asked if there is an incentive created by a capital charge. I think that the question or your skepticism would apply equally if you asked the same question but changed operating risk to credit risk or market risk. There are incentives for good managers to manage credit risk. There are incentives for good managers to manage market risk. The thing is that people aren't perfect, markets aren't perfect, events happen, things go bump in the night.
    Mr. FRANK. How does having a capital charge help then?
    Mr. DEWHIRST. Capital is there to protect the bank and the bank shareholders and the——
    Mr. FRANK. Okay, but it is not an incentive. It is——
    Mr. DEWHIRST. The capital is there to protect against economic loss.
    Mr. FRANK. Right.
    Mr. DEWHIRST. If the system is one that gives you a lower capital charge to the extent that you are better able to control your risk, whether it is credit or operating or whatever, then you have an incentive to control that.
    Mr. FRANK. You think the analogy between credit risk and operational risk follows very closely?
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    Mr. DEWHIRST. Sure. In the examples mentioned earlier, many of the operating risks mentioned were kind of minor and routine, like fraud. And my opinion is they are not so much for those routine losses as for the bigger ones.
    Mr. FRANK. Like what?
    Mr. DEWHIRST. Market timing, like late trading. If a company doesn't have the right kind of controls in place over its operations to make sure that people don't do those things, they can lose a lot of money, and capital is there to make sure that that——
    Mr. FRANK. Okay. Let me ask you this, though—and I would appreciate a little extra time if I could—of course what you are saying is if you have those controls in place, you will then get a reduction in the capital charge?
    Mr. DEWHIRST. I would hope that eventually that is where the system goes.
    Mr. FRANK. Oh, that is very attenuated. It is not currently—you wouldn't get any today? Because it can't be an incentive if you don't get it. Is that not built in today?
    Mr. DEWHIRST. Certainly, on the capital side, the direction we would move——
    Mr. FRANK. No, I am not talking about on the operational risk side. You are saying——
    Mr. DEWHIRST. There has been an evolution in the regulation that starts with formulas like 20 percent risk weights for securities and has evolved towards an actual assessment of losses on credit risk. On the operating risk side, to the extent that you have an advanced approach, what I would expect to see happen is that your own data and models that project how much you could lose would tend to support a particular capital level, and as the regulators get more confidence in your loss history and your projections of future losses, your own history of good risk management ought to lead you to lower capital——
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    Chairman BACHUS. Mr. Frank——
    Mr. FRANK. I have one last question, which is I thought we were talking about unexpected losses, and how does that fit into——
    Chairman BACHUS. Let me do this: Let me recognize Mr. Murphy and then I will come back.
    Mr. FRANK. All right. I apologize.
    Chairman BACHUS. Mr. Murphy?
    Mr. MURPHY. Thank you, Mr. Chairman. I only have a time for a quick question here, although there is nothing quick when we are talking about the Basel Accord.
    But a question for Mr. Elliott. I know the Fed has done a preliminary study on the effect of Basel II on mergers and acquisition activity within the whole banking industry. It concluded that any potential drop in capital accompanying the accord would have little impact on merger activity. However, they did admit that because of relevant data, and I quote here, ''The results are statistically insignificant, and in cases where results are statistically significant, quantitative magnitudes are small.'' What is your opinion of the study and statements like that?
    Mr. ELLIOTT. My perspective on that is that it is like any study, it is a little bit backward looking, it is not forward looking. And when you look in terms of the potential consolidation of the financial services industry, obviously the winners are going to be the ones that have the large capital resources to basically provide acquisition opportunities. And if you don't have strong capital, you are not going to participate in the consolidation of the financial services industry.
    So my view would be it is an interesting study but more backward looking, and any evaluation has to be more forward looking in nature.
    Mr. MURPHY. Are there elements here in the accord which would help or hinder—and I guess I will open this up to all the panelists—help or hinder the flexibility of allowing institutions to move forward in best ways with regard to mergers and acquisitions. I mean the idea being that we don't want it to just be a couple of big players end up acquiring everything but allow the marketplace to work here. Are there elements that you think help or hinder overall?
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    Mr. ELLIOTT. Potentially it helps the larger financial organizations to the extent they free up capital from some of the other aspects of the Basel II Accord. You do have to take into consideration, however, that basically the marketplace is going to be the real determinant around the amount of capital you need in a consolidating type environment. Others may have a different view.
    Mr. MURPHY. Any other panelists have a comment on that?
    Ms. MARINANGEL. I do. I think that when the larger banks that would be able to adopt Basel II would be able to deploy their capital, I believe that they would be able to buy a competing smaller institution and then convert those assets into a more efficient use by having less capital required. And so I think that that will encourage mergers and acquisitions to occur, because they will be able to deploy the capital of the acquired bank.
    Mr. MURPHY. Is that a positive or negative?
    Ms. MARINANGEL. Well, I think that perhaps for those community banks that want to be sold, it is a positive. But I think it is a negative long term because I believe that community banks serve functions in the communities that the large banks sometimes can't address. So I think it would be a negative. There are a lot of de novos that are opening to service the needs of communities as community banks.
    Mr. MURPHY. Thank you.
    Mr. Gilbert, you had a comment?
    Mr. GILBERT. Just to take a different view, I just believe that regulatory capital will have no role in bank decisions about whether to merge or acquire another bank. As Mr. Dewhirst said, we make our decisions on all sorts of factors, largely driven by our economic signals, economics of the marketplace. Regulatory capital is not on the radar screen as a drive of decision making in that regard.
    Mr. MURPHY. So we have some differences of opinion here? Well, that helps clarify this point.
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    Mr. MURPHY. Thank you, Mr. Chairman. I remain obfuscated by the——
    Mr. DEWHIRST. I guess I would say or ask you in any article you have ever read about a bank merger, did anybody ever talk about regulatory capital as a driver? It is never on the table.
    Ms. MARINANGEL. It could be, though, in the future because of Basel II.
    Mr. MURPHY. Thank you, Mr. Chairman.
    Chairman BACHUS. Thank you, Mr. Murphy.
    Ms. Maloney?
    Mrs. MALONEY. First of all, I would like to welcome one of my constituents, Michael Alix, and thank you for your testimony today.
    I would like to ask you about your—you mentioned in your testimony the trading book. Can you elaborate on this issue and discuss how it may impact your firm and similar firms under Basel II?
    Mr. ALIX. I would be delighted to, thank you. The trading book is a concept in the Basel Accord which allows positions and businesses to have their regulatory capital calculated using a market risk model. And the idea behind the trading book is that assets that are in the trading book are marked to market, held for sale and actively managed as market risks. That describes virtually all of the activities of the major investment banks. There are some exceptions, but virtually all of the inventory positions and activities in the investment banks would be encompassed in a trading book.
    However, it also includes activities which in commercial banks are in a banking book, and a banking book is more of a held-to-maturity traditional lending concept. And what we fear from our discussions with regulators, both in the U.S. and around the world, is that the activities that we have effectively managed for years and years as market risks could be recharacterized as banking risks.
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    That includes, for instance, mortgages purchased with the intent to securitize, loans purchased with the intent to sell. Those activities are recharacterized as banking book activities. It has two harmful effects. Number one is it causes us to have to build infrastructure to collect data and make calculations on those activities that we wouldn't otherwise do for our own purposes. We would not think it would be relevant information.
    And the other thing it does is to create a disparity in the actual capital charge between the banking book and the trading book such that investment banks, which have already recognized the expected loss in the activity through the mark-to-market process, would then be asked to take a capital charge on top of that. The reserves, which banks would hold against those activities, and which are, in some measure, expected losses, would continue to be allowed as capital under the Basel Accord. So that disparity would cause us a concern.
    Mrs. MALONEY. Thank you. Getting back to the point that Mr. Frank was making, and I would like to ask all the panelists to comment if they would, why would it not be more advantageous to all United States financial sector institutions to move operational risk to Pillar 2 and disclosure under Pillar 3? And wouldn't that solve the competitive problems better and protect better against risk, with the regulators and supervisors looking at it. Would anybody like to comment on that?
    Mr. ELLIOTT. Well, that is precisely our proposal, and we think one of the things that you have outlined is basically getting to the heart of the matter. Each individual organization is different here, and it is very difficult to take something that is really unproven, basically mathematical formulas, and try to level set it as it relates to a capital charge. We think the aspect of regulators understanding an organization and its activities well goes a long way to answering the operational risk aspect. Disclosures, we think, just continue to add to the transparency that has been discussed. So we would be very much of a like mind with yourself.
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    Mrs. MALONEY. I would like all the panelists to answer if they would. What would your position be on moving operational risk to Pillar 2 and disclosure under Pillar 3?
    Mr. GILBERT. Thank you. As I mentioned in my testimony, I think if you had a Pillar 2 approach to operational risk, you can imagine your supervisor coming to you and saying, ''Okay, we are here to discuss how you handle operational risk and whether you adequately address it in your risk measurement and capital systems. So please now show us the data that you have collected that helps us understand how you have adequately addressed this particular issue.''
    That is the same exercise, essentially, that you would go through to have a Pillar 1 capital charge. In fact, if you did that across the board, subject to standards that are broadly agreed in the industry as part of Pillar 1, you would have a much more consistent framework than a bilateral discussion that would not only go on here but across the world for banks that we actively compete with across a wide range of businesses. So we just think it improves the transparency to make that a Pillar 1 charge.
    In terms of the point about unproven, I think we and other banks have been doing operational risk internal capital for some time. We think it is working quite effectively, and so we would challenge the idea that it is unproven.
    Mrs. MALONEY. Sir?
    Mr. DEWHIRST. My comments are very similar. First, on the consistency and transparency point, I think it is evident that you would have more consistency and better transparency with models that are publicly discussed and used——
    Mrs. MALONEY. But why would it be more transparency? Why would it be more transparent?
    Mr. DEWHIRST. Imagine the situation, as Mr. Gilbert suggested, where each regulator at each bank has a somewhat idiosyncratic approach to assessing the risks at that bank. The constituents who care about risk management at that bank, shareholders for example, would not know exactly what idiosyncratic standard those regulators were——
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    Mrs. MALONEY. But if you had it under Pillar 2 and Pillar 3, which Pillar 3 is just disclosure, wouldn't it be totally disclosed? If it is under Pillar 3, it would be totally disclosed. Why wouldn't it be transparent if it is required to be disclosed?
    Mr. DEWHIRST. Disclosure is an area where it is difficult to achieve a standard which is high enough that everybody learns what they—in other words, you have disclosures in a lot of other areas that still create confusion, and I think that——
    Mrs. MALONEY. What if we had a standard for disclosure?
    Mr. DEWHIRST. If you have a standard for disclosure that really explains how risk is being done in a consistent way across the system, you would have to have a methodology that was consistent as well.
    Let me just add one other comment on the maturity of the process. The comment that operating risk management is so new that we can't do it I think is contradicted by the fact that the insurance industry has been looking at these kinds of risks and analyzing them in a very statistical way and projecting losses for many, many decades. And what we are really talking about is just an extension of many of those same techniques.
    Mrs. MALONEY. I would feel that it would be better to move the operational risk to Pillar 2, the abstract nature of operational risk. I believe a capital charge would not have any significance towards operational risk, and I would not want to see a capital charge for operational risk. I would rather have it be disclosed or have regulators discuss it as they do currently.
    Ms. JANSKY. I believe that we need to consider the fact that it would take some time to develop for a lot of institutions, perhaps not all of those that are at the table today, but for a number of us to go back and develop all of the information that is necessary and to develop that over long periods of time to really build the models that support operational risk at our institutional level. Our big concern is it is going to take quite a bit of time, so we would support moving to Pillar 2.
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    Mr. ALIX. I think our firm and the firms I am speaking on behalf of in theory agree with the idea of a Pillar 1 requirement and in theory agree that there ought to be capital set aside for failures of people, processes and systems. Those failures are inevitably going to happen, and there ought to be, as we do a better job in the Basel II Accord, a much better process of measuring and isolating the unique market and credits risks, which for the most part create a reduction in capital requirements. To have an isolation of capital for operational risks would be, in theory, a good thing.
    In practice, it is very difficult, and while some institutions have made some significant progress, we, in looking at some of the methodologies that are out there, are somewhat skeptical of their applicability to our firms. And so we would like to ensure that if we continue along the path of having a Pillar 1 capital charge for operational risk, that it be sensitive to the unique operational risks that our firms wear and not try to apply a one-size-fits-all approach.
    Mrs. MALONEY. My time has expired—unless you had a point to make.
    Mr. GILBERT. I just wanted to make one additional comment if I could. Basel II is a package that includes judgments to credit and operational risk charge. If we were to remove the operational risk component from Pillar 1 without knowing in great detail, my sense is that the supervisors would feel compelled to recalibrate the rest of the remaining Pillar 1 and capital framework, and that is market risk and credit risk in particular.
    And I think that the law of unintended consequences would take over, because you would force them to kind of recalibrate in a way that would move the credit risk charge in particular away from the underlying dimensions of risk, and that would be unfortunate, because what we are trying to do in Basel II, in the first instance, is link those risks more closely.
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    Mrs. MALONEY. Could I do a brief follow-up question on this just to try to clarify it from the statement and Mr. Gilbert and Mr. Dewhirst? Basically, are you saying that because we have several financial regulators, that we would not be able to achieve consistency or transparency through supervision? Is that your point? Could you clarify a little more?
    Mr. Gilbert and Mr. Dewhirst, from your comments.
    Mr. GILBERT. It is not just that we have several regulators in the United States. We have regulators all across the world, and so absent some very clear standards which are the core of Pillar 1, because Pillar 1 isn't just a formula in which you calculate a capital requirement but rather it comes with operational standards that the supervisors expect the banks to adhere to.
    Without the consistency that is associated with those standards as well as the calculation itself, what you end up having through Pillar 2 is really a whole series of bilateral discussions across—in our case, across 50 countries that becomes unworkable and in inevitably will be inconsistent and not transparent. And, therefore, we would be concerned about something like that in the Pillar 2 framework, and the Pillar 1 framework makes that much more explicit.
    Mrs. MALONEY. Thank you.
    Mr. DEWHIRST. And I would just add that even if you imagine a world where there were one regulator, you have different examiners in charge of exams at various institutions, and there is variability among the set of standards that they apply, which is inevitable because they are people.
    To the extent that you have a uniform approach that they are attempting to adhere to, you minimize that, and specifically you see a regulator issue a set of guidelines for how they examine a particular risk. If you don't have uniformity, then you risk a lack of consistency.
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    Mrs. MALONEY. Thank you for that clarification, and thank you for the time, Mr. Chairman.
    Chairman BACHUS. Thank you.
    Ms. Jansky, in your testimony, you mentioned the arbitrary minimum capital standards that have been set for commercial real estate lending.
    Ms. JANSKY. Yes, sir.
    Chairman BACHUS. Why do you think that our U.S. regulators agreed to these arbitrary capital lending minimums?
    Ms. JANSKY. I could only guess about that, sir, but I would say that I think that a great deal of work apparently had been done, and they were looking back in time and looking at asset correlations and asset performance over the last two or three cycles. My concern with that is there are a lot of other factors that have to be taken into consideration. There were lots of reasons for the different cycles that we went through.
    There has been lots of change since those, particularly the last commercial real estate cycle, as it relates to both the introduction of FDICA but also it relates to the elimination of the tax incentives that existed back in the 1988 era when we had so much oversupply of product that was built, not because of demand in the marketplace but frankly because of tax incentives.
    We have asked a lot of questions. We have asked for empirical evidence, we have asked to see support, and we frankly have just yet to see anything that we find that leads us to that same conclusion.
    Chairman BACHUS. Do you think they could be more concerned about maybe risk management in Europe as opposed to here?
    Ms. JANSKY. I can't answer that question, sir, I don't know.
    Chairman BACHUS. Okay. But you have pretty clearly testified that you believe it will have a negative effect on commercial real estate lending in the United States?
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    Ms. JANSKY. I believe it can have a negative impact in certain products as we begin to rationalize and begin to work towards an efficient utilization of capital, those products that require higher capital, if you cannot get the right price in the market or the price tends to be higher than perhaps non-financial institutions providing that product, I do think we will see it become an issue for certain markets. Yes, sir, I do.
    Chairman BACHUS. And if the capital charges for certain acquisitions and development and construction loans remain as drafted, will SouthTrust—or SunTrust——
    Ms. JANSKY. I don't think SouthTrust is worried about it.
    Chairman BACHUS. New Wachovia, right?
    Will SunTrust and other institutions, you think, be—I will just say SunTrust—be forced to make fewer loans?
    Ms. JANSKY. I wouldn't say today, because I really think it is too early to say that, that we would be forced to make fewer loans, but I would say that that line of business, as all of our lines of business, as we assess the capital required to run our total operation as we get more efficient there, we will look at the capital allocation for that line of business, and it may force them to reconsider what their targets are in the market.
    Chairman BACHUS. Okay. I will ask this question of all witnesses. There have been significant innovations in commercial real estate risk assessment that have been employed in the last 10 years, and I think, Ms. Jansky, you mentioned that. Do you believe that acquisition development and construction lending has gotten more or less risky over the past 10 years?
    First of all, I will ask—just start with you, Mr. Elliott. Do you think it is more risky or less risky?
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    Mr. ELLIOTT. The perspective that we have is that we, in essence, are not in that line of business, so mine would be a little bit more as an outside observer. I think an outside observer's perspective would be that I think people understand the risks a lot more, they have monitored the risks a lot better than what they would have historically, and people have built their loan portfolios in a much more diverse manner so that to the extent they do have any issues inside the portfolio, they are able to handle them from a financial perspective.
    Chairman BACHUS. Does Mellon do residential lending?
    Mr. ELLIOTT. Very selectively for high networth individuals, yes.
    Chairman BACHUS. Okay. Do you think that that has become less or more risky?
    Mr. ELLIOTT. I think it has become less risky because the way that we do it. We have very low loan-to-value type ratios associated with it, and we typically have other collateral associated with those loans in addition to the property.
    Chairman BACHUS. But you all just aren't in that market that much.
    Mr. ELLIOTT. We are not a significant player, no.
    Chairman BACHUS. How about, Mr. Gilbert, JPMorgan Chase and I guess Bank One now?
    Mr. GILBERT. Yes. Thank you. My new partners at Bank One I think are more engaged in the real estate lending business than we have been at JPMorgan Chase, but I think I would agree with Mr. Elliott on the comments about the relative riskiness. But, of course, the thing to keep in mind is that relative risk in this type of activity is also a function of the State of the economy, and we have generally had a benign economic environment, certainly for in the nineties. We had some problems early, of course, in this decade, but you can see that it is a lot—that the economic environment on the whole is a lot better than, say, the previous decade.
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    And I think if you take a long historical view, I think, as the Fed has published in its study on real estate, you find that this is not a riskless activity by any means, but you can make relative risk statements about various points in time, but I think what is most prudent to do is take the longest possible historical view.
    Chairman BACHUS. Okay.
    Mr. Dewhirst?
    Mr. DEWHIRST. My answer is colored mainly by my experience in New England and history at Fleet there. New England went through a very traumatic period in the real estate market in the nineties. I think that taught people some lessons about mismanagement and underwriting, and so I would say that market has become much less risky over time. And I would also echo Mr. Gilbert's comments that the business cycle seems to be becoming less volatile, and that helps credit risk in general, including both commercial and residential real estate.
    Chairman BACHUS. Ms. Marinangel?
    Ms. MARINANGEL. I agree that the acquisition development and construction lending have become less risky. Being in the Midwest, that is generally a stronger economy, and because of the interest rate cycles as well, I believe that it has become less risky. Hopefully, it will stay that way, but when you have good business environment, generally it is less risky.
    Chairman BACHUS. All right.
    And Ms. Jansky, you have already testified that it has become less risky, I believe, both residential and commercial, in your opinion?
    Ms. JANSKY. Yes, sir. I would just comment that I believe that we have had a lot that is happened over the last 10 years and the advancement of risk management practices in our industry. I also believe there is a great deal more transparency in the commercial real estate market. I also believe that real estate developers have had a much more consistent approach to market and have been somewhat more conservative than I observed over the last 25 years in the business.
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    Having said that, I am not sitting here today and saying that there won't ever be additional real estate problems because there will, but I believe that the industry has done a very, very good job, and I believe a lot of regulation in certain areas, but at the time we would have been careful but now it looks to me like we are very prudent and it has helped us to make sure that we are managing that risk. And I think the industry as a whole is managing it much better.
    We also have to remember that we have had some very high vacancy factors across the country in different markets. We have had lots and lots of new starts that have been pulled from the market, but we have been in an incredibly low interest rate environment. So you have to balance all of that as you look at the relative risk. But we feel very comfortable with it, and we just want to see a lot more documentation and more of a forward thinking about the risks associated with commercial real estate.
    Chairman BACHUS. Mr. Alix, Bear Stearns is not really in that market.
    Mr. ALIX. I would suggest that we are but in a very different way than the other panelists. One of the things that hasn't been mentioned I think as a positive in commercial real estate lending has been the enormous development of a robust capital market for securitized commercial real estate loans.
    And our firm, as well as others in the industry, have a very active business in originating and purchasing loans from other originators, packaging those loans in large and diverse packages—diverse by geography, diverse by property type, et cetera—and selling pieces of those securitizations to institutional investors.
    That has diversified the ultimate holders of the risk and has ensured that if there were a problem, another problem in commercial real estate lending, the pain would be distributed a little bit differently than it was the last time around. So I think that is a very positive development.
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    I also believe that this is an area where our argument for trading book treatment is crucial, because these are loans that if we applied banking book, which the other witnesses argue is extremely conservative, if we apply banking book capital charges to our commercial real estate loans held for securitization, it would have a very detrimental effect on the regulatory capital charge.
    Chairman BACHUS. All right. Thank you. You know, I will say we are going to hold a hearing tomorrow on non-prime lending, and I am sure we will touch on securitization in that lending is somewhat threatened by some liability questions, as you know.
    I will say this—I am going to yield to Mr. Frank for as much time as he may consume. Before I do that, I do want to say—I want to offer one cautionary note that I have as far as the residential real estate lending market, and that is we have been in a historic period, I would say, for the past several years of low interest rates where people that weren't able to afford mortgages before because of low interest rates were—many of those residential mortgages are adjustable rate mortgages.
    And I am not sure that if we have rising interest rates out of a very low interest rate, residential mortgages and adjustable rate mortgages as opposed to fixed rate mortgages, I am not sure what kind of stress that will put on the market. I am not sure that we—I am sure you all factored some of that in. Anybody want to comment on that? Is that a concern?
    Mr. ALIX. I would suggest, as a firm that has a significant mortgage capital markets business, that prudent risk management would compel us to do sensitivity analysis and stress analysis for the sort of scenario that you are describing. And one observation would be that the market seems to have absorbed the increase in volatility and interest rates in the mortgage markets quite well, but time will tell as to whether the ultimate home value and delinquency rates are affected by a materially higher interest rate environment.
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    Chairman BACHUS. All right.
    Mr. Dewhirst?
    Mr. DEWHIRST. Well, certainly, it is a concern, and it is one that we have looked at for many years. When you get burned once in a particular area, you tend to focus on that for the rest of your life. The one caveat I would put around the growth in the ARMs market is that many of the most popular ARM loans have a fixed period that is quite long in the front. So I just bought a house myself in Charlotte, preparing to move down there, and it is not only an ARM but there is 10 years of fixed rate in front of it.
    So I think there is a possibility that in just looking at aggregate ARM numbers, we can exaggerate the exposure. Many of the people that have 5-, 7-, 10-year ARMs will have moved or refinanced by the time that those fixed rate periods end.
    Chairman BACHUS. That is a good point. I am not sure I was considering that.
    Mr. Frank?
    Mr. FRANK. I want to return to the question of incentive, et cetera, and I would say I agree with Mr. Dewhirst. I have advanced the argument that you can't do the operational risk capital charge because we don't know how to measure it, but it does seem to me that acknowledging that they have made significant progress in measuring it cuts the other way as well. That is, I understand the importance of some uniformity and standards and the problems of inconsistent application.
    I don't understand what a capital charge adds to that. That is, why can't you do all those things you were talking about, promulgating uniform standards, et cetera, under a management approach? What does promulgating a number, a capital charge, add to that administrative procedure, because I agree with everything else you have talked about.
    The second point I would have is this: You said that the incentive works this way, which is logically straightforward as you say it. Once there is a capital charge, you would get an incentive to improve your procedures because that way your capital charge could be lowered. But the people who would decide to lower the capital charge are the people who are checking. I don't understand why you would still have the same group of people monitoring your procedures.
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    Now, without a capital charge, they are monitoring your procedures and passing on their adequacy. With a capital charge, they are monitoring your procedures and passing on their adequacy so they can reduce the capital charge. I literally don't understand how a capital charge adds to the transparency, the rationality. All those things could be done, it seems to me, by administrative regulation and requirement without a capital charge.
    So, particularly, for Mr. Gilbert, I guess, and Mr. Dewhirst. I would be interested in your responses.
    Mr. DEWHIRST. Let me make two—well, a comment and ask a question, sort of turn it around and maybe I can get clarity on what your concerns are.
    Banks already hold capital. There is implicitly a capital charge for operating risk. If large losses occur because of operating risk losses, the shareholder pays.
    Mr. FRANK. Mr. Dewhirst, I understand that, but that is not answering my question.
    Mr. DEWHIRST. Well, then let me try to understand it by asking this.
    Mr. FRANK. Go ahead.
    Mr. DEWHIRST. We insist on a certain approach to credit risk. We say there ought to be a methodology for deciding how much risk there is in the assets we have, what the possibility is of unexpected losses occurring in those assets, and we ought to have capital that is scaled to that. What is different about operating risk?
    Mr. FRANK. Well, I think there are some differences in terms of what you are dealing with. Loan losses are expected, but I do want to go back to your question. I have to say this: When you don't want to answer my question but want to ask me one in return, it suggests to me you haven't thought of the answer yet. I will take it in writing later.
    But you were saying that a capital charge deals with the following problems. First of all, it deals with the problem of inconsistent regulators. Was I correct in hearing you that way, that you said that one of the problems that leads you to be for capital charge is the difference and inconsistency among regulators; is that correct?
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    Mr. DEWHIRST. A capital charge under the advanced approach. We could do that.
    Mr. FRANK. Yes. Right. And that is a way to get around—to diminish the problem of inconsistent regulators. It would increase transparency. You would have one set of standards. My question to you is why can't you accomplish all of that by regulation and by promulgations without a capital charge and don't in fact even if you have a capital charge, you still need to get them together and do that.
    I think that what you are saying is, well, only if there is a capital charge—the capital charge in and of itself doesn't do any of that. The capital charge does not homogenize or regularize or get uniform. You still have the individual basis. Why is the capital charge necessary to achieve all those other things which I think we ought to achieve?
    Mr. DEWHIRST. You may be able to achieve consistency and transparency without the capital charge.
    Mr. FRANK. No, that is not my question. My question is what does the capital charge add to it?
    Mr. DEWHIRST. I understand. What it adds is what capital adds for every other risk, which is a cushion against loss.
    Mr. FRANK. Okay. Then that is a different question, I understand that. And that is what I was asking my question, but that is a different justification than the one you gave. That is fine.
    Mr. DEWHIRST. It was——
    Mr. FRANK. Excuse me, I am going to finish. I have to be honest with you, even if you weren't moving out of my district, I would still interrupt you. You are moving to Charlotte, so I don't mean to—I do that with people.
    Mr. DEWHIRST. Not before the next election.
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    Mr. FRANK. Weak opposition this time. It is not a problem.
    But here is the point. Here is the point: If you had said that originally, we wouldn't be having this discussion. I understand that argument that a capital charge is there to provide money to make up for the risk, but in addition to that, and I really think you have to deconstruct all these arguments, there is an argument that a capital charge incentivizes you, et cetera.
    In other words, one argument for capital charge is that it diminishes the likelihood that there will be risk which the capital will be used to fill up, and the argument that you need a capital charge to deal with losses, I understand. I would have dealt with that earlier if we had gotten to it earlier. The argument that a capital charge improves the quality of regulations somehow increases transparency and deals with the problem of inconsistent regulation, I am unpersuaded.
    Mr. DEWHIRST. Let me make a distinction. Again, it is based on my analogy to the credit risk capital framework. Under Basel I, all commercial loans were 100 percent risk weight. Not all commercial loans have the same amount of risk. The capital charge did not do anything for transparency or did not do much for transparency. It did a lot for consistency but not a lot for transparency. It certainly didn't tell the shareholder or the debt holder in a particular bank whether the loans were extremely risky or not.
    The advanced approach goes to a very different standard where the capital assigned is going to be proportional to the risk assessed, based on estimates of probability of default, loss if default occurs, exposure and so on. Under that system, there would be an incentive—the capital charge would create an incentive for better risk management, because to the extent that you could reduce probability of default or loss given defaults, you would have a lower capital charge. Now, if we can——
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    Mr. FRANK. But you have a lower capital charge only if the regulator examined your procedures and felt that you had achieved increased efficiency and therefore you were entitled to a lower capital charge.
    Mr. DEWHIRST. Yes.
    Mr. FRANK. And my question to you is why can't we have the regulator do that without the capital charge? In other words, in each case—excuse me, I want to finish this—in each case, we are relying on the regulator's analysis of what you have done and the regulator having analyzed what you have done says, ''Oh, you did a pretty good job.'' Well, why can't we give the regulator the power to enforce that? Why does he need the ability to reduce the capital charge to have the ability to do that?
    Mr. DEWHIRST. If you again go to the credit example, with 100 percent risk weights for all commercial loans, the regulator comes in——
    Mr. FRANK. Well, you are going back and forth with the credit example. The credit example is sometimes relevant and sometimes isn't. If you can't answer it in terms of the operational risk, then I am skeptical.
    Mr. DEWHIRST. The analogy to operating risk would be exactly——
    Mr. FRANK. Well, explain to me then why does the regulator need a capital charge to be able to look at those procedures, evaluate them and pass judgment on them?
    Mr. DEWHIRST. They don't, but then what happens?
    Mr. FRANK. Okay.
    Mr. DEWHIRST. In order for there to be an incentive—I mean there could be banks that are extremely well capitalized, very well capitalized, marginally well capitalized that a regulator would come in and—I mean a regulator just wants to have a certain level of capital so they can ensure the safety and soundness.
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    Mr. FRANK. I didn't say that. That is the loss to me. That is a separate argument, and I would like to return to the one we are talking about. It is very important to sort them out.
    Mr. DEWHIRST. I am sorry, say that again.
    Mr. FRANK. That is the loss provision, to make up for losses, but that is a separate one from the—I mean I did notice you said it didn't add to transparency. I mean I am trying to understand what it is over and above capital to make up for losses that makes it important to have a capital charge. I don't understand how it adds to transparency, how it adds to the incentive, how it—I mean you still haven't gotten to me on that.
    Mr. DEWHIRST. Under the current system, I would say transparency is minimal because—and I am going to the lending approach because what is happening now is the regulators are trying to make the operating risk approach more like the lending approach. But under the current lending approach, 100 percent risk weight for all commercial loans, it is very hard for anybody to know what is going on, because it is 100 percent for every kind of loan. You don't get detail.
    If the system went to the advanced approach and capital were allocated by risk, then you would know both from the process and probably from the disclosures that banks that had more capital for credit risk had more risk.
    Now, if you did the same thing under the operating risk framework, you could have two different approaches. One approach would just be all banks or all financial institutions have a certain level of risk. One of the early Pillar 2 approaches said operating risks in proportion to revenue.
    Mr. FRANK. That is a strawman, nobody said that. But it is a strawman, it doesn't help us to throw it in here.
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    Mr. DEWHIRST. But it is very similar to——
    Mr. FRANK. No, it isn't. What we are talking about is—we have agreed that there needs to be—and I am going to end this now because we are not getting anywhere—we need—yes, we want to have a system whereby the regulators look at things individually and at the same time you want both individuality and uniformity. You want regulators looking institution by institution, but you want regulators with each institution to have a somewhat similar approach. I agree with that. I just don't understand how at the end—beginning or ending with a capital charge in any way makes that likelier or easier to accomplish.
    That is all, Mr. Chairman. We are going to end where we began.
    Chairman BACHUS. Thank you. I am going to go ahead now and ask a question, and then Ms. Maloney will wrap up, but at least you have some——
    Mr. FRANK. I am going to lunch, Mr. Chairman. I am going to go have lunch.
    Chairman BACHUS. We are all going to lunch pretty quick here, including some students over here.
    I have one question. It is actually for Mr. Alix, it is something you raised in your testimony. This spring we heard testimony from the U.S. and European government officials regarding the consolidated supervision issue. You talked about your concerns there. Last week, the International Subcommittee heard testimony from the U.S. financial sector regarding this issue as well. The securities industry in particular has now asked the committee I think for two weeks in a row to keep a close eye on the implementation of the commission's consolidated supervision directive.
    So my question is this: What should members of this committee do in monitoring this situation?
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    Mr. ALIX. Well, first, I would say, as I said in the testimony, that we believe it should be unambiguous. There is no doubt that the SEC's form of supervision, which is embodied in the consolidated supervised entities rule, is first rate, world class, equivalent to the best supervisory programs around the world for financial institutions. And I think that the best thing that the people in this room and elsewhere in this city can do is to push the European representatives to abide by their deadlines in making that determination.
    And if that determination is made, for instance, in the next few weeks, I think that will enable U.S. investment banks to get on with the business of making their applications and getting the exams done and putting themselves in a position without undue cost or burden to meet the requirements that the SEC has put forward. If there is a delay, that could be very damaging, both from the perspective of having to do more in less time as well as from the perspective of having the commission distracted by that particular issue still being open.
    So we want it to be unequivocal, clear and final as soon as possible, and anything you can do to make that concern known to the appropriate people would be appreciated.
    Chairman BACHUS. What if the European Commission and I guess the parliament can't conclude or finalize their work and make the necessary determinations in a timely manner? What could the Financial Services Committee do about this internally?
    Mr. ALIX. Well, first of all, I don't think the equivalence judgment is a matter for the European parliament. I think that has been delegated to each firm's respective regulator of their principal activities in Europe. And so that is a matter for the regulatory agencies in Europe. To be honest, I think it is not something that we contemplate.
    As I said, it is so obvious to us that it is something that we believe ought to be done right away. Were that not to happen, I think that would be sufficiently serious that it would inspire very high level across-Atlantic conversations about the implications, and I think that for our firms the prospect of having our operations ring fenced in Europe and not being able to enjoy the benefit of global franchises would make it very difficult to compete in some of our core businesses in Europe. And I think that would be very detrimental.
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    So, as I said, I would like not to contemplate a significantly longer delay or a decline of equivalence status, but if that were to happen, we would be very, very concerned.
    Chairman BACHUS. I would ask all of you if your firms or your corporations have researched whether the regulators in the various countries have the legal authority to share supervisory information or oversight responsibilities, possibly join together in enforcement actions across borders?
    Mr. GILBERT. I am not sure we have researched it as such. I think in those matters we tend to rely on the supervisors to discuss among themselves their ability to share information and pursue actions. We, of course, need to abide by the local rules that apply to the sharing of information, even within our own firm, so there are a lot of rules and requirements out there that can vary from country to country. But in terms of the ability of the supervisor to share information——
    Chairman BACHUS. And really legal authority.
    Mr. GILBERT. Right. We tend to have not looked per se at that issue but, again, rely on the bank supervisors themselves to determine that.
    Mr. ALIX. If I might add, I would agree that it is a question better placed with the regulatory authorities here who have done the legal research, but it is my understanding that the SEC in the case of the investment banks has negotiated agreements with the relevant regulatory authorities about the protection of private information that they exchange in the course of their supervisory activities.
    I think it is kind of interesting because we actually support cooperation among regulators to avoid, for instance, being asked the same question or being asked for the same information by 10 different regulators around the world. We would encourage them, where appropriate, to consult with each other and share information where it is directly relevant to carrying out their activities.
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    Chairman BACHUS. All right. This concludes our hearing, and members will have five legislative days to submit opening statements. And the chair notes that some members may have additional questions for the panel, which they may wish to submit in writing. Without objection, the hearing record will be held open for 30 days for members to submit written questions of those witnesses and to place their responses in the record.
    With that, this hearing is adjourned.
    [Whereupon, at 12:15 p.m., the subcommittee was adjourned.]