via e-mail
THE FINANCIAL SERVICES ROUNDTABLE
November 3, 2003
Ms.
Jennifer J. Johnson
Secretary, Board of Governors
Federal Reserve System
20th Street and Constitution Avenue, NW
Washington, D.C. 20551
Office of the Comptroller of the Currency
250 E Street, SW
Public Information Room, Mailstop 3-6
Washington, DC 20219
Regulation Comments
Chief Counsel's Office
Office of Thrift Supervision
1700 G. St, NW.
Washington, DC 20552
Robert E. Feldman
Executive Secretary
Attention: Comments
Federal Deposit Insurance Corporation
550 17th Street, NW
Washington, DC 20429
Re: Risk-Based Capital Guidelines,
Implementation of New Basel Capital Accord
Dear Sirs or Madams:
The Financial Services Roundtable (the
"Roundtable") represents 100 of the largest integrated financial
services companies providing banking, insurance, and investment products
and services to the American consumer. Roundtable member companies
provide fuel for America's economic engine accounting directly for $18.3
trillion in managed assets, $678 billion in revenue, and 2.1 million
jobs. The Roundtable appreciates the opportunity to comment to the Board
of Governors of the Federal Reserve System (the "Board"), the Federal
Deposit Insurance Corporation ("FDIC"), the Office of the Comptroller of
the Currency ("OCC"), and the Office of Thrift Supervision ("OTS")
(collectively, "the agencies") on the advance notice of proposed
rulemaking to implement the new Basel Capital Accord ("Basel II" or the
"New Accord") in the United States.
Introduction
The Roundtable notes its tremendous
respect for the diligence and stamina of the regulators who have worked
on the New Accord. We appreciate the efforts of Board Vice Chairman
Roger Ferguson, who has met with Roundtable member companies several
times to listen to our concerns. Comptroller Hawke and FDIC Chairman
Powell also have been very open to our ideas throughout the long process
of developing the New Accord. We look forward to continuing this
dialogue as the New Accord moves closer toward formal adoption and
throughout the implementation period.
The Roundtable and its member companies
have been active in the Basel II consultation process, submitting
several comment letters to the Basel Committee on Banking Supervision
and testifying before both the House Committee on Financial Services and
the Senate Banking Committee. The Roundtable supports the goal of
revising the existing capital adequacy requirements for internationally
active banks. We agree with the overall objectives of the New Accord,
which include creating a better alignment of regulatory capital to
underlying economic risks, promoting better risk management, and
fostering international consistency in regulatory standards.
The New Accord would replace the 1988
Basel Capital Accord, which is viewed as increasingly outdated. The
impact of the New Accord on financial institutions, the financial
marketplace, and evolving methods and practices of risk management will
be far-reaching. Implementation of the New Accord poses significant
challenges for banking institutions as well as regulators. There will be
a bifurcated supervisory framework in the United States: one for the
core banks and opt-in institutions and another for all others, which
will continue to use current risk-based capital rules for measuring
capital. The Roundtable offers the following comments to the agencies in
an effort to relate the concerns of the industry and to assist with the
difficult task of implementing the New Accord.
• The New Accord is prescriptive,
unnecessarily complex and costly to implement
• There will likely be conflicts
between home and host country supervisors
• There is a potential competitive
disadvantage among U.S. banks, foreign banks and U.S. non-banks
• The cumulative effect of conservative
assumptions made throughout the New Accord should be recognized
• Some have questioned whether the
capital requirements of the New Accord may adversely affect lending
during an economic downturn (pro-cyclicality)
• The operational risk capital charge
remains the subject of debate
• The Pillar III disclosure rules are
burdensome
• The capital requirements for various
types of assets may be a disincentive for certain markets
• The treatment of expected losses
should be modified
The New Accord is Prescriptive,
Unnecessarily Complex and Costly to Implement
1. Prescriptive Rules - The New
Accord shifts the regulatory emphasis toward a highly complex,
formula-based system, and will diminish the important role that is
currently played by human judgment. These international rules could
bring a more formulaic, inflexible style of regulation to the United
States, which currently enjoys a reasonable balance between black letter
rules and supervisory consultations. Most of this prescriptiveness is to
be found in Pillar I, but as described below the detailed prescriptive
requirements for disclosures under Pillar III are also problematic.
Implementation of these rules will be costly, but not necessarily cost
effective. It is important that the detailed requirements and
implementation of the New Accord not interfere with the future evolution
and refinement of risk models among the most sophisticated banks.
The Roundtable recommends that the focus
be on simple basic requirements, largely around the key input parameters
and exposure calculations, and that the agencies publish best practices
that provide guidance to banks and supervisors rather than a rigid
rulebook. We recommend that, in applying the New Accord and reviewing
the eligibility of systems under the IRB and AMA approaches, the
agencies seek to avoid dictating the form and structure of a bank's risk
management system, and that the agencies put more weight on Pillar II.
Pillar II allows supervisors to adjust an individual bank's capital
requirements on a case-by-case basis to address risks not adequately
reflected in the Pillar I quantitative formulas.
2. Cost - The monetary cost of
complying with the New Accord will be significant. Implementation,
especially the advanced methods for determining credit risk and
operational risk charges using internal models, will require banks as
well as regulators to devote substantial resources to new systems and
personnel training. One of our member companies has estimated that the
initial costs will be in the tens of millions of dollars to implement
the system, plus multi-million dollar ongoing costs. Other estimates
vary, but all agree that establishing and maintaining the new systems
will be a major undertaking. Some of these costs will be passed on to
consumers, and in some cases these costs could force banks to
discontinue certain activities, leaving these markets to unregulated
entities.
3. Adaptability - The proposed
Basel rules are based on the financial markets as they are today.
However, the rules are so complex and heavily negotiated that they may
be difficult to update over time. The New Accord requires banks to use
specific processes for internal management in many areas, regardless of
whether they are relevant for business practices. If bank management is
required to compute and manage by the New Accord's rules, further
improvements in internal practice might be seen as both costly and
irrelevant. The New Accord should not be permitted to slow the progress
and introduction of better private sector risk management techniques.
Adopting a more "principles-based" approach, subject to some reasonable
benchmarks and guidelines for consistency, has important natural
advantages compared to the "black-letter" style rules currently proposed
under Pillar I. It would encourage banks and regulators to work together
over time to improve risk management practices, rather than forcing
compliance with a dated rulebook. A principles-based approach would
permit steady, evolutionary improvement and therefore should be more
durable and relevant than Pillar I rules that are designed with only
today's markets in mind.
There Will Likely be Conflicts between
Home and Host Country Supervisors
The complexity of the new rules poses
particular challenges for international banks that are regulated by
supervisors in a number of countries. The Roundtable endorses comments
made by Board Vice Chairman Ferguson in June 2003 indicating that the
U.S. regulators expect to accept the New Accord approaches and
calculations followed by a bank's home country supervisors when
evaluating an international bank with U.S. branches, as well as for
purposes of eligibility of financial holding company status.
The Roundtable supports the principles
outlined in the Basel Committee's Publication No. 100 titled,
"High-level Principles for the Cross-Border Implementation of the New
Accord," especially the recognition of primacy of home country
supervisors on capital issues. We also endorse the Committee's
recommendation that home and host country supervisors organize practical
plans of cooperation prior to the implementation date, with a view to
improving supervisory efficiency and reducing the implementation burden
on banks.
The Roundtable hopes these efforts will
develop lasting mechanisms to resolve home/host country conflicts in a
timely and predictable manner, both during and after the implementation
period. Roundtable member companies are concerned about the potential
for inconsistent regulatory supervision for internationally active
banks, and by the high compliance costs that may result from the need
for parallel, but different, capital calculations in multiple regulatory
jurisdictions. The Roundtable recommends that the U.S. agencies take a
proactive, leadership role in working with their foreign counterparts in
an effort to address these concerns.
There is a Potential Competitive
Disadvantage among U.S. Banks, Foreign Banks and U.S. Non-Banks
Regulators should work closely to ensure
that United States banks will not be competitively disadvantaged vis
a vis foreign banks and U.S. non-banks. In the U.S., non-bank
competitors such as investment banks, finance companies and insurance
companies make up a large part of the financial system. The Basel rules
do not apply to them. If the costs of the New Accord are high, banks
will earn a lower return on capital, will grow more slowly, and will
lose market share. There may even be some incentives to abandon certain
businesses or to de-bank altogether.
The OCC and others have questioned
whether the New Accord will be enforced less vigorously on banks in some
other countries. If so, this could create competitive inequality between
U.S. and foreign banks. We recommend that U.S. regulators keep this is
mind when implementing the New Accord and that they continue to work
with their foreign counterparts in achieving the appropriate balance in
these areas.
The Cumulative Effect of Conservative
Assumptions Made throughout the New Accord should be Recognized
Many of the requirements and standards in
the New Accord are unduly conservative. Examples include: floors on
capital minimums; the forced use of conservative loss given default ("LGD")
and exposure at default ("EAD") parameters in several portfolios; 99.9%
confidence interval requirements; stress test assumptions; the 60 basis
point floor on asset value correlations for retail exposures; the 20%
limit on insurance in offsetting operational risk capital charges; the
limited recognition of future margin income; the lack of recognition of
double default effects in credit risk mitigation; the significantly
higher capital charges required for equity investments; and the absence
of any quantitative recognition of the risk reducing benefits of
diversification in portfolios and business lines. Taken individually,
each such assumption or decision is debatable. Taken together, the
cumulative effect of these separate decisions is a much more
conservative, prescriptive and burdensome Accord. The agencies are urged
to consider industry concerns over the excessively conservative tilt to
the proposed New Accord when reviewing implementation issues and in
calibrating the final Accord. In addition, Pillar II should expressly
state that supervisory reviews will permit discussions between banking
organizations and their regulators in identifying situations where some
elements or assumptions of Pillar I formulas are unrealistic and
adjusting or reducing capital cushions accordingly.
Some Have Questioned Whether the
Capital Requirements of the New Accord May Adversely Affect Lending
During an Economic Downturn (Pro-Cyclicality)
The new rules will change how banks
calculate and manage their capital and the amount of business they
choose to do. If Basel II banks all respond to economic changes and
risk-based capital requirements in a similar manner - as they may tend
to do under a common regulatory regime - this could significantly
increase or decrease liquidity in the credit markets and ultimately
affect the real economy.
Roundtable member companies have
different views on whether the New Accord would significantly increase
pro-cyclicality and ultimately affect the economy. Some believe that the
new rules will affect banks' calculation and management of capital
during economic downturns, thereby exacerbating liquidity concerns.
Other member companies believe that more risk-sensitive capital
requirements will not lead to pro-cyclical lending, if prudently
managed.
The current Pillar II proposals require
each bank to develop a credit risk "stress test" that is directly linked
to possible additional capital requirements. The exact parameters for
this test remain unclear but the language suggests it amounts to an
extra layer of buffer capital so that banks will not need to dig into
their core capital in difficult times. The Roundtable suggests that
either the New Accord or the U.S. implementation rules include an
explicit acknowledgment that capital levels may fluctuate, and that
Pillar II reviews and stress tests should not become one-way ratchets
that only increase regulatory capital requirements. If a stress test is
to work properly and reduce pro-cyclicality, then banks should be
permitted to live within their plans during difficult times, and
regulators should resist the temptation to continue to require the same
untouched capital cushion.
The Operational Risk Capital Charge
Remains the Subject of Debate
In addition to reforming capital charges
for credit risk, the New Accord establishes a new capital charge for
operational risk - the risk of breakdowns in systems and people. It is
important to distinguish between the concepts of managing operational
risk and imposing a separate, quantitative capital requirement for it.
The operational risk capital charge proposed by the Basel Committee has
produced much debate among financial institutions. The Roundtable's
member companies agree that evaluating and controlling operational risk
is important and should be required as a supervisory and business
matter. Roundtable members do not agree on whether or how operational
risk should be reflected in regulatory capital calculations. Many
companies believe operational risk can best be addressed through
case-by-case supervisory reviews under Pillar II; others favor a
quantitative and a publicly disclosed capital charge under Pillar I.
The Pillar III Disclosure Rules are
Burdensome
Pillar III seeks to enhance market
discipline through increased public disclosure requirements. The New
Accord requires that a bank make extensive additional disclosures about
its risk profile and risk management process. The Roundtable firmly
supports transparency and disclosure as worthwhile goals; however, many
of the detailed proposals in the Pillar III market disclosures section
are burdensome and technical and would impose a significant competitive
disadvantage on banks compared to institutions not subject to the
Accord.
While the latest draft reduced somewhat
the list of disclosures compared to earlier versions, more streamlining
is needed. The Pillar III proposals require voluminous disclosures that
are highly technical in nature and which we believe would be of little
benefit to the reader. Indeed, few people are able to digest all of the
information that is already presented on risks. Under the New Accord,
relevant information could be lost in a deeper, more technical mass of
data. The additional requirements proposed under Pillar III are more
likely to confuse than illuminate.
Of particular concern are the numerous
required disclosures that relate directly to the capital calculations
performed within Pillar I. Instead of disclosing measures of risk used
in internal risk management systems, these disclosures mandate an
explicit regulatory capital view of risk. In the most complex areas,
such as asset securitization, these disclosures will surely be
mystifying to all but the most expert audiences.
Moreover, there is a need to ensure that
risk management practice is able to mature beyond the concepts now
embedded in the New Accord proposals. Just as the market has moved
beyond the current accord, there inevitably will come a time when some
Pillar I calculations are no longer regarded as good measures of risk
for all products. In that case, it must be possible for banks to alter
disclosures to represent emerging best practices without waiting for
formal changes in the New Accord Under Pillar III as currently proposed,
banks will likely find themselves constrained to disclosing risks under
a system that is no longer wholly relevant.
The Roundtable recommends replacing
Pillar III's list of specific items with more flexible disclosure
principles. Other concerns about Pillar III that we believe need further
consideration include preserving the confidentiality of sensitive and
proprietary information; the potential for increased risk of litigation
or liability in mandating disclosure of information that is of doubtful
relevance, misunderstood or, in the case of operational risk, focused on
hypothetically significant but unpredictable and unlikely events; and
the effect of Sarbanes-Oxley Act officer certifications and other
provisions. Roundtable members are also concerned about the added
burdens of frequent Pillar III disclosures. We believe that most of the
new required items should be disclosed only annually, not quarterly.
The Capital Requirements for Various
Types of Assets May be a Disincentive for Certain Markets
The Roundtable believes that the capital
requirements proposed for various types of assets, particularly
securitized debt and commercial real estate loans, are sufficiently high
as to have the unintended and unnecessary consequence of being a
disincentive for those markets. The Roundtable believes that the New
Accord should be constructed with the intent of having a neutral effect
on these and other financial activities. The Roundtable offers the
following comments on the effect of the New Accord in various lending
areas.
1. Asset Securitization
Asset securitizations are a cornerstone
of how the U.S. markets finance residential mortgages, consumer credit
card balances, automobile loans and other receivables. The
securitization rules in the New Accord are potentially very burdensome,
and often difficult to interpret. The result is that only a few experts
in each area are likely to understand these specialized rules.
The various approaches to securitizations
under the New Accord have raised some concern in the financial services
industry. Roundtable member companies do not believe that the
Standardized Approach, Ratings Based Approach ("RBA"), or the
Supervisory Formula Approach ("SFA") will provide a viable method for
measuring required capital for liquidity facilities.
In many cases, under the New Accord,
securitization will tend to increase the capital charge assigned to the
same pool of assets. For example, the originating bank would be charged
with capital on the full risk of the asset pool if it retained an
exposure at least equal to KIRB. Investing banks that purchased
securities in the securitization also will be charged significant
capital, meaning that the total capital required of the banking system
will be higher than if the assets had not been securitized.
This is a very important issue for the
U.S. markets in particular, as compared to markets in other countries,
which are much less reliant on securitization technology. The proposed
approach will raise costs for funding U.S. consumer loans and other
asset classes where securitization techniques are important. The
Roundtable is concerned that the additional costs and burden resulting
from the application of these rules will negatively impact the
attractiveness of this type of financing, resulting in higher cost of
financing in the capital markets and negative consequences for the U.S.
economy as a whole. The Roundtable welcomes the Basel Committee's
October 11th announcement that the treatment of securitization will be
revised and the Supervisory Approach will be replaced with a less
complex approach. We urge the agencies to continue to take a leading
role in the discussion on securitization issues because of their
importance to the U.S markets.
2. Commercial Real Estate
Commercial Real Estate ("CRE") lending
constitutes an important component of the loan portfolios for many
banks. The New Accord's requirements may have a significant impact on
these institutions' competitive positions compared to non-bank lenders.
Roundtable member companies believe that the credit risk charges for
"high volatility" CRE are too high as compared with other corporate
exposures.
There is no industry data that indicates
that acquisition, development, and construction ("ADC") loans are higher
in volatility or pose any greater risk than investment real estate loans
or corporate and industrial ("C&I") exposures. Many ADC loans are
supported by collateral and guarantees, which are an effective risk
transfer mechanism. Also, many construction loans have duration of less
than three years. This mitigates the likelihood of financial
deterioration for the obligor or guarantor and reduces the need for
excess capital.
3. Residential Mortgage Lending
There are still some outstanding issues
in determining the minimal regulatory capital charges for single-family
residential mortgages. The 15% asset value correlation ("AVC")
assumption assigned to residential mortgage loans should be reviewed.
Industry surveys suggest loans with
initial loan to value ("LTV") ratio above 80% perform very differently
than lower LTV loans. To avoid excessive credit risk charges, the
correlation factor should be lower for low LTV loans and be higher as
one moves up the LTV scale. It may be appropriate for low LTV loans to
have an AVC of 10% and high LTV loans to have an AVC of 20% or higher.
The 10 percent floor on LGD figures for
residential mortgages should be eliminated or reduced since LGD is well
below 10 percent for many banks' mortgage portfolios. The Roundtable is
also concerned about whether the New Accord will recognize private
mortgage insurance appropriately, and the treatment of different types
of residential mortgage loans, including first mortgages, home equity
loans and home equity lines of credit. Many believe that these mortgage
loan categories should be separated in risk weight calculations.
4. Retail Lending
The Roundtable is pleased that the Basel
Committee is revisiting the treatment of credit card commitments and
related issues. We agree that the New Accord's approach to credit card
portfolios needs improvement.
Retail lenders have forecasted capital
requirements in this area that contradict the Committee's goal of
capital neutrality. The Committee's Third Quantitative Impact Study ("QIS
3") predicts that regulatory capital required for Qualifying Revolving
Exposure ("QRE") portfolios will increase by 16 percent beyond the
regulatory capital required by the current risk-based capital rules,
while regulatory capital required for mortgage and other retail
portfolios could decrease substantially, by 56 percent and 25 percent
respectively.
Despite significant work by the U.S.
banking agencies and retail lenders, the Roundtable believes that the
capital curves for QREs remain inappropriately calibrated. Based on the
data accumulated thus far, unsecured retail lenders could be severely
damaged by the New Accord, and the economies that depend on consumer
lending could be significantly damaged as a result. In some
circumstances, the additional capital required to operate these business
lines could be the marginal cost that drives certain consumer lenders
out of business. The Roundtable is concerned that the New Accord's
current assumptions and mathematical models for QRE portfolios would
produce the associated credit risk and substantially harm both the
competitive position of credit card lenders and their ability to
continue certain lines of business. Specifically, the QRE curve could
require retail lenders to hold regulatory capital against lower-risk
assets that do not properly reflect the credit risk presented by those
assets. Banks would respond to that incentive by holding excessive
capital for low-risk loans, potentially leading lenders to prefer to
hold riskier assets in their portfolios.
The Roundtable is particularly concerned
about the proposed approach to undrawn lines of credit for on- and
off-balance sheet credit-card assets, which we believe substantially
drives the capital impacts projected in QIS 3. The New Accord would take
the position that financial institutions must consider the likelihood of
additional drawings on the unused portion of a credit card line when the
bank determines its loss estimates. Under the IRB approaches (but,
interestingly, not under the Standardized Approach), the bank must
incorporate those risk assessments into the bank's calculation of EAD or
LGD. We believe that this requirement could lead to a significant and
unwarranted increase in the amount of capital that banks must hold
against credit card accounts. As such, we strongly oppose this provision
as we believe that it does not accurately reflect the true risk exposure
faced by institutions engaged in this type of consumer lending.
Cancelable commitments do not require
regulatory capital to be held against them for several reasons. Lenders
will only permit future draws when appropriate capital funding is
available, so up-front capitalization is unnecessary. As draws are
booked, the lender increases capital in an amount sufficient to preserve
the correct capital ratio. If at any point additional capital becomes
unavailable, the lender immediately withdraws open lines. Future draws
on open-to-buy are contingent on adequate future capital access. As
such, there is no need to set aside capital in anticipation of future
exposure. With cancelable commitments, capital at default will always be
adequate for exposure at default if capital is simply accumulated as
draws are booked.1
The Treatment of Expected Losses
Should be Modified
Expected losses ("EL") are already taken
into account by banks in pricing loans and other products and in
determining appropriate levels for loan loss reserves. The current draft
of the New Accord provides only partial recognition for loan loss
reserves and the loss absorption capacity of predictable future
revenues. For U.S. institutions in particular, it is not clear that the
offsets for loss reserves would be fully available under current
accounting practices. The Roundtable therefore welcomes the agencies'
recent agreement to reconsider the treatment of EL and the inclusion of
reserves in capital. Our members are currently reviewing the Basel
Committee's October 11 proposal on EL, and we look forward to further
details and discussions. Recalibration of the Pillar I formulas
resulting from excluding EL and future margin income should be
approached with care.
It is not clear if the October 11
proposal to adjust regulatory capital to reflect excesses or shortfalls
in loan loss reserves compared to EL under the IRB approach implies a
change in the definition of regulatory capital for all purposes. If so,
and the result is a different definition of capital for Basel II banks
and non-Basel II banks, the broader implications of this for comparing
institutions, competitive equality an cross-references to total or Tier
1 capital in other contexts (e.g. prompt corrective action,
leverage ratios, lending and investment limits, etc.) should be
considered carefully.
Conclusion
We appreciate your consideration of the
Roundtable's views on these important issues. The Basel Committee and
the agencies have invested substantial resources into developing the New
Accord and preparing for its implementation. However, more remains to be
done. The timetable for implementation is challenging, particularly
since the New Accord requires a minimum of three years of data for the
advanced calculations. The Roundtable supports the Basel Committee's
recent decision to postpone finalization of the New Accord until
mid-2004. The Accord should benefit from further review of the important
issues and industry concerns that remain to be resolved. In the pressure
to finalize and implement the New Accord, we hope that enough time will
be provided for everyone - banks and supervisors alike - to think about
the implications of the New Accord, and to develop appropriate
implementation rules. Furthermore, the Roundtable recommends that enough
phase-in time be provided so that when the New Accord is implemented,
there will be no issues that will negatively affect the financial
services industry or the U.S. economy in general.
If you have any further questions or
comments on this matter, please do not hesitate to contact me or John
Beccia at (202) 289-4322.
Sincerely,
Richard M. Whiting
Executive Director and General Counsel
The Financial Services Roundtable
Washington, DC
________________________________________
1
The New Accord already
recognizes that cancelability is a critical determinant of capital
needs. For example, the New Accord suggests that the Credit Conversion
Factor for securitized uncommitted retail lines should range from 0% to
40%, depending upon excess spread, while the Credit Conversion Factor
for committed retail lines is always 90%, regardless of spread. This
distinction presumably acknowledges the more manageable exposure of
cancelable lines, a feature that is also relevant for the calculation of
on-balance sheet capitalization needs. Furthermore, the New Accord also
suggests that the Credit Conversion Factor for certain uncommitted
corporate facilities is 0%, versus 75% for committed facilities. We
believe this logic should be extended to uncommitted retail facilities,
particularly QRE's.
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