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PR-16-2003 (02/27/2003)
Media Contact:
Phil Battey (202) 898-6993

Thank you, Mr. Chairman and members of the Subcommittee.

Since 1999, the Basel Committee has worked hard to develop a new international capital framework, referred to as "Basel II." I entered this effort late in the game – having joined the FDIC 18 months ago – and I am grateful to my fellow supervisors and their staff for the efforts to get us where we are today.

Bank capital is critical to the health and well–being of the U.S. financial system. An adequate capital cushion enhances banks' financial flexibility and their ability to weather periods of adversity. The conceptual changes being considered in Basel II are far–reaching. For the first time, we would create one set of capital rules for the largest banks and another set of rules for everyone else. Under the proposed new Accord, large banks will feed their internal risk estimates into regulator–defined formulas to set minimum capital requirements. Under the new formulas, minimum capital requirements for credit risk would tend to be reduced, with additional capital being held under a flexible operational risk charge.

Admittedly, the existing capital rules for the largest banking organizations have not kept pace with these institutions' complexity and ability to innovate. Basel II intends to align capital with the economic substance of the risks large banks take. This is a worthy goal. Nevertheless, before regulators and policymakers embrace Basel II, the FDIC has concluded that three critical issues need to be addressed.

First, minimum capital requirements must not be unduly diminished. Lower capital requirements for credit risk, together with a set of more flexible capital charges imposed by supervisors, may work well in theory. Experience demonstrates, however, that it is difficult for supervisors to impose substantial capital buffers in the face of stiff bank resistance, especially during good economic times. Substantial reductions in minimum capital requirements for the largest U.S. banks would be a grave concern to the FDIC.

Second, we must be satisfied that the regulators can validate internal risk ratings. By allowing the use of banks' internal risk estimates, Basel II represents a significant shift in supervisory philosophy. This new philosophy demands that we have in place uniform and consistent interagency processes that are effective in assessing whether the banks' internal estimates are reasonable and conservative. These processes are being developed by the agencies but the work here is not final.

Third, we must understand and assess the competitive impact of Basel II. Basel II will most likely be mandatory only for a group of large, complex and internationally active U.S. banking organizations. This mandatory group of institutions does not include numerous large, regional banking institutions, as well as thousands of smaller, community-based banks and thrifts. If Basel II provides the largest U.S. institutions some material economic advantage as a result of lower capital requirements, the "non–Basel" institutions may find themselves at a competitive disadvantage in certain markets. This "bifurcated" system raises the concern of competitive inequity between these groups of banks. Banks themselves are best equipped to evaluate these issues. We regulators, in turn, must provide them with straightforward, dollars and cents information about the Accord and the capital they or their competitors may be required to hold.

The FDIC will work with our fellow regulators to address these issues in the months ahead.

Presuming these threshold issues are satisfactorily resolved, numerous Accord implementation issues still need to be decided. I will touch on two of them in my remaining time. To fully adopt the internal ratings based approach proposed in Basel II, banks must make significant investments in staff expertise, internal controls, and make the necessary structural – and cultural – changes. Qualifying for and living with Basel II will bring complexity and burden. Of course a degree of regulatory complexity is unavoidable as banks seek to have capital tailored to their individual risk profiles. But, these burden considerations, and the desirability of testing the waters with the new Accord, suggest that the universe of "Basel II banks" initially will and should be relatively small.

The proposed capital charge for operational risk has attracted much discussion. Bank failures related to operational risk can be traced overwhelmingly to one common theme—fraud. This is certainly part of the reason banks hold capital. Whether the operational risk charge is called

Pillar 1 or Pillar 2 is not of critical significance to the FDIC, provided the regulators implement this approach in a commonsense, flexible manner.

Finally, in implementing the Accord we must not forget the importance of credit culture and the virtues of conservative banking. The Basel II internal risk estimates are likely to be only as robust as the credit culture in which they are produced. Rigorous corporate governance structure, effective internal controls and a culture of transparency and disclosure, all play an important role in ensuring the integrity of banks' internal risk estimates. It will be important for supervisors not to place excessive reliance on quantitative methods and models. Models can be wrong, and losses can depart from historical norms. That is why we need a margin for error.

To repeat an earlier point, that is why we need capital.

Thank you for the opportunity to present the views of the FDIC.

Attachment: Statement of Donald E. Powell Chairman Federal Deposit Insurance Corporation on the New Basel Accord before the Subcommittee on Domestic and International Monetary Policy, Trade, and Technology of the Committee on Financial Services U.S. House of Representatives 10:00 AM February 27, 2003 Room 2129, Rayburn House Office Building

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Last Updated 02/27/2003 communications@fdic.gov