Statement of
Sheila C. Bair Chairman
Federal Deposit Insurance Corporation
on the
Interagency Proposal Regarding the Basel Capital Accord;
before the
Committee on Banking, Housing and Urban Affairs;
U.S. Senate; 10:00 A.M.; Room 538,
Dirksen Senate Office Building
September 26, 2006
Chairman Shelby, Senator Sarbanes and members of the Committee, I appreciate the
opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC)
concerning the Basel II international capital accord.
The Importance of Capital
The U.S. banking system is a network of institutions that are highly leveraged and
whose financial health bears directly on the health of our broader economy. Significant
problems or a lack of financial flexibility at many small banks, or at one or more large
systemically important banks, can have contagion effects that impose significant costs
on the deposit insurance funds and the overall economy. The special role of banks in
our economy creates a federal interest in their sound operation and the adequacy of
their capital.
Economic theory describes an important rationale for bank capital regulation. The
theory asserts that banks may tend to hold less capital than is optimal for prudential
purposes. When calculating economic capital needs, banks do not consider the
substantial costs that their potential failure would impose on other parts of the economy.
In addition, a bank's depositors and creditors benefit from explicit and perceived safety-
net protections. This benefit lowers the premium banks must pay for deposits and other
forms of debt. The result is a greater proportion of debt and a lower proportion of capital
in banks' overall funding mix than would exist in the absence of federal safety net
support.
In the United States, we have a dual system of bank capital regulation. Banks' Tier 1
capital, the high-quality capital that is most critical in absorbing losses, is required to
exceed defined percentages of balance sheet assets. This leverage ratio requirement
provides a baseline of capital for safety-and-soundness purposes. However, the
leverage ratio does not address all risks. For example, it does not address the risks of
off-balance sheet positions. Risk-based capital requirements provide a second
measurement of capital to capture risks that are not addressed by the leverage ratio.
The purpose of the Basel II process is to improve the current risk-based capital
requirements. In designing and implementing these improvements, it is important to
Sheila C. Bair Chairman
Federal Deposit Insurance Corporation
on the
Interagency Proposal Regarding the Basel Capital Accord;
before the
Committee on Banking, Housing and Urban Affairs;
U.S. Senate; 10:00 A.M.; Room 538,
Dirksen Senate Office Building
September 26, 2006
Chairman Shelby, Senator Sarbanes and members of the Committee, I appreciate the
opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC)
concerning the Basel II international capital accord.
The Importance of Capital
The U.S. banking system is a network of institutions that are highly leveraged and
whose financial health bears directly on the health of our broader economy. Significant
problems or a lack of financial flexibility at many small banks, or at one or more large
systemically important banks, can have contagion effects that impose significant costs
on the deposit insurance funds and the overall economy. The special role of banks in
our economy creates a federal interest in their sound operation and the adequacy of
their capital.
Economic theory describes an important rationale for bank capital regulation. The
theory asserts that banks may tend to hold less capital than is optimal for prudential
purposes. When calculating economic capital needs, banks do not consider the
substantial costs that their potential failure would impose on other parts of the economy.
In addition, a bank's depositors and creditors benefit from explicit and perceived safety-
net protections. This benefit lowers the premium banks must pay for deposits and other
forms of debt. The result is a greater proportion of debt and a lower proportion of capital
in banks' overall funding mix than would exist in the absence of federal safety net
support.
In the United States, we have a dual system of bank capital regulation. Banks' Tier 1
capital, the high-quality capital that is most critical in absorbing losses, is required to
exceed defined percentages of balance sheet assets. This leverage ratio requirement
provides a baseline of capital for safety-and-soundness purposes. However, the
leverage ratio does not address all risks. For example, it does not address the risks of
off-balance sheet positions. Risk-based capital requirements provide a second
measurement of capital to capture risks that are not addressed by the leverage ratio.
The purpose of the Basel II process is to improve the current risk-based capital
requirements. In designing and implementing these improvements, it is important to
recognize both the inherent limitations on the ability to precisely measure bank risk, and
the fundamental fact that supervisors' and banks' objectives in the capital regulation
process are not always the same. Thus, the more reliance the risk-based capital
regulation places on banks' internal risk estimates, the more important is the hard-and-
fast capital baseline provided by the leverage ratio. As discussed later in this testimony,
the critical importance of the leverage ratio in the context of the Advanced Approaches
of Basel II is an issue that is worthy of discussion in the international arena, as well.
Basel II
As you know, Basel II is an international effort by financial institution supervisors with
the laudable goal of creating standards for capital requirements that are more risk-
sensitive and promote a disciplined approach to risk management at this country's
largest banks. Basel II also is intended to address concerns that the regulatory arbitrage
opportunities available under Basel I threaten the adequacy of the regulatory capital
buffer needed to ensure financial system stability. U.S. bank regulators also are
developing a more risk sensitive capital framework known as Basel IA for non-Basel II
banks.
Basel II includes several options for banks to calculate their risk-based capital
requirements. Basel II's Advanced Approaches allow banks to determine their risk-
based capital requirements by using their own estimates of key risk parameters as
inputs to formulas developed by the Basel Committee. The Advanced Approaches also
contain an operational risk capital requirement that is based on each bank's own
estimates and models of its potential operational losses. The key risk parameters used
to determine capital requirements for credit risk and operational risk in the Advanced
Approaches are subject to supervisory review. The principal issues with respect to the
Advanced Approaches revolve around how banks will set their risk inputs and the
formulas that translate these inputs into capital requirements. The Advanced
Approaches to Basel II include significant expectations for banks to have high quality
risk management systems and have stimulated banks' efforts in this area.
Basel II also provides for a Standardized Approach to calculate risk-based capital
requirements. The Standardized Approach includes a greater array of risk weights than
the current rules, an expanded set of options for recognizing the benefits of collateral
and other credit risk mitigants, and new options for computing exposures to derivatives.
In addition, the Standardized Approach includes new capital requirements for certain
exposures not captured by the current rules, such as short-term loan commitments and
the potential for early amortization of revolving credit securitizations. The Standardized
Approach also includes a capital charge for operational risk.
The FDIC Board of Directors voted to publish the Basel II Notice of Proposed
Rulemaking (NPR) for public comment on September 5, 2006. As the U.S. banking and
thrift agencies proceed with the deliberative process for implementing Basel II, it is
important that the new capital framework does not produce unintended consequences,
such as significant reductions in overall capital levels or the creation of substantial new
the fundamental fact that supervisors' and banks' objectives in the capital regulation
process are not always the same. Thus, the more reliance the risk-based capital
regulation places on banks' internal risk estimates, the more important is the hard-and-
fast capital baseline provided by the leverage ratio. As discussed later in this testimony,
the critical importance of the leverage ratio in the context of the Advanced Approaches
of Basel II is an issue that is worthy of discussion in the international arena, as well.
Basel II
As you know, Basel II is an international effort by financial institution supervisors with
the laudable goal of creating standards for capital requirements that are more risk-
sensitive and promote a disciplined approach to risk management at this country's
largest banks. Basel II also is intended to address concerns that the regulatory arbitrage
opportunities available under Basel I threaten the adequacy of the regulatory capital
buffer needed to ensure financial system stability. U.S. bank regulators also are
developing a more risk sensitive capital framework known as Basel IA for non-Basel II
banks.
Basel II includes several options for banks to calculate their risk-based capital
requirements. Basel II's Advanced Approaches allow banks to determine their risk-
based capital requirements by using their own estimates of key risk parameters as
inputs to formulas developed by the Basel Committee. The Advanced Approaches also
contain an operational risk capital requirement that is based on each bank's own
estimates and models of its potential operational losses. The key risk parameters used
to determine capital requirements for credit risk and operational risk in the Advanced
Approaches are subject to supervisory review. The principal issues with respect to the
Advanced Approaches revolve around how banks will set their risk inputs and the
formulas that translate these inputs into capital requirements. The Advanced
Approaches to Basel II include significant expectations for banks to have high quality
risk management systems and have stimulated banks' efforts in this area.
Basel II also provides for a Standardized Approach to calculate risk-based capital
requirements. The Standardized Approach includes a greater array of risk weights than
the current rules, an expanded set of options for recognizing the benefits of collateral
and other credit risk mitigants, and new options for computing exposures to derivatives.
In addition, the Standardized Approach includes new capital requirements for certain
exposures not captured by the current rules, such as short-term loan commitments and
the potential for early amortization of revolving credit securitizations. The Standardized
Approach also includes a capital charge for operational risk.
The FDIC Board of Directors voted to publish the Basel II Notice of Proposed
Rulemaking (NPR) for public comment on September 5, 2006. As the U.S. banking and
thrift agencies proceed with the deliberative process for implementing Basel II, it is
important that the new capital framework does not produce unintended consequences,
such as significant reductions in overall capital levels or the creation of substantial new