In late May and early June, supervisory staff from the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Reserve met with approximately seventy-five bankers at three separate regional outreach meetings (with about twenty-five bankers at each meeting). The first meeting was held on May 22 at the Federal Reserve Bank of New York, the second on June 2 at the Federal Reserve Bank of Chicago, and the third on June 3 at the Federal Reserve Bank of Atlanta.¹ The meetings were intended to engage the bankers in discussion about proposals for the new Basel Capital Accord (Basel II) and how implementation in the United States would be carried out. The bankers attending these meetings represented large institutions that currently are not included in the group of mandatory Basel II banks, but that are likely candidates to consider opting in.

In general, supervisors felt the objectives of the meetings were met, namely communicating information about Basel II to the bankers, hearing their feedback, and encouraging them to provide detailed comments on existing and upcoming documents. Below is a summary of points discussed at the meetings, organized by topic, including questions and comments from the bankers.²

1. the Basel II framework has already benefited from various consultations and impact studies; however, no decisions made to date are irrevocable, and banks still have an opportunity to influence the outcome through their comments on the proposals;
2. detailed comments on existing and forthcoming Basel II-related documents, including draft supervisory guidance, are very important if bankers wish to affect the U.S. implementation of the proposed capital framework.
3. all non-mandatory banks would have the option of applying Basel II, provided they meet the supervisory standards, but in no way are supervisors applying pressure for them to do so;
4. as Basel II moves forward, supervisors believe it is in the interest of both bankers and supervisors to maintain a steady dialogue about the framework and its implementation; and
5. Basel II advanced approaches are designed to encourage banks to refine their risk management processes.

Staff then presented a short overview of Basel II and described proposed U.S. implementation (see accompanying presentation "U.S. Implementation of Basel II"). Particular attention was drawn to the bifurcated capital regime that would be created under Basel II, with the majority of institutions probably remaining on the current capital rules.

Bankers had a number of questions in response to the overview/scope presentation. Several questions referred to the decisionmaking process for possible opt-in (i.e., non-mandatory banks). Staff stated that banks in this group should start identifying fairly soon where they are in the decisionmaking process, conduct due diligence about the potential costs and benefits, and then begin to decide whether they want to opt in to Basel II, and if so, by when. It was acknowledged that information required for banks to make a thorough decision about Basel II is still forthcoming, such as the advance notice of proposed rulemaking (ANPR) and draft supervisory guidance. Staff indicated that the opt-in decision need not be documented for supervisors, but that if a bank were to choose to opt in, supervisors would fairly soon thereafter want to have an informal discussion with the bank about its plan to qualify. Staff made it clear that adopting the framework on a piecemeal basis, e.g., portfolio by portfolio, would not be acceptable, and that the Advanced Internal Ratings-Based (A-IRB) approach and the Advanced Measurement Approach (AMA) would have to be adopted at the same time. In addition, U.S. organizations would have to adopt the advanced approaches to Basel II on a consolidated basis.

Other questions related to the existing Prompt Corrective Action (PCA) framework and whether it would be altered under Basel II. Staff responded that the current PCA rules, including the leverage ratio, would remain in place and that the levels would remain unchanged. Some bankers inquired about the potential changes to the current capital rules, such as the existing treatment of corporate loans, and whether they would be affected by Basel II over time. Staff responded that, as has been the case in the past, the existing capital rules might change as potential improvements arise; these may or may not be influenced by Basel II, but right now there are no plans to make immediate changes.

A number of questions related to the current timeline for implementation, particularly for banks looking to adopt by January 2007. Supervisors explained that any bank wishing to initiate Basel II in January 2007 would be required to conduct a parallel run of Basel II and the current rules starting in January 2006. In addition, this would mean that, because of certain requirements for data collection, banks would have to start collecting data in January 2004. However, there would be perhaps a bit more flexibility with respect to the "use test" requirement, since supervisors would be looking for practices that "broadly" matched those for Basel II over the three years leading up to January 2007. Also, the use test would not apply to internal capital calculations, which are expected to be different from regulatory capital, but would relate to the bank's assessment of risk. There were some comments that supervisors should not be too heavy-handed with the use test, and that there should be clear and specific rules about supervisory requirements in that area.

Several banks, as subsidiaries of foreign banking organizations, raised questions about the international consistency of Basel II rules applied at the national level and how cross-border operations would be treated in the United States--what are known as "home/host country" issues. Staff explained the role of the Basel Accord Implementation Group (AIG) in trying to harmonize implementation across countries and find solutions for issues relating to home/host supervision. There was some discussion about the potential for parent organizations of foreign banks to adopt Basel II approaches that will not be available in the United States (such as foundation IRB) and that having no fallback to the advanced approaches in this country could represent a high hurdle for some. Staff explained that U.S. supervisors will make every effort to assist U.S. subsidiaries of foreign banks in providing necessary inputs to their parent and allowing them to remain compliant with whatever approach the parent applies on a consolidated basis. Coordination among national supervisors will be paramount, and whenever possible burden will be reduced. In certain cases, where U.S. supervisors can comfortably rely on the evaluation of the home country supervisor, assessing the U.S. subsidiary along Basel II lines will run much more smoothly. In the end, supervisors will take into consideration institution-specific issues--while maintaining consistent standards in the application of Basel II.

In response to questions, staff stated that the criteria for mandatory banks are not likely to change, but that some additional banks, through natural growth or through acquisition, may come into the mandatory set over time. A few questions were directed at the overall rationale for Basel II as a new regulation and whether supervisors should simply pursue the goal of better risk management through the supervisory process. One response from staff indicated that this could place banks in a difficult spot, because they would be held to high supervisory standards without benefiting from added risk sensitivity in their regulatory capital measures.

Some bankers exhibited strong concerns about the potential competitive impact of Basel II, and whether it might fundamentally change the U.S. banking landscape. The concerns centered on the possibility that large banks operating under Basel II would have a significant capital advantage and thus could offer more attractive pricing and demonstrate better earnings. There were also statements that Basel II could create distortions for mergers and acquisitions.

Staff asked whether internal capital allocations (economic capital), as opposed to regulatory capital charges, were more often the binding constraint in business decisions. Some bankers responded that economic capital is more often the driver, and that Basel II could remove incentives for capital arbitrage, thereby improving efficiency. But others noted that in some cases regulatory capital was higher than economic capital (often because diversification across business lines is not used in the former), and thus a constraint. It was not clear whether the need to comply with PCA rules was the source of this observation. Also, Basel II might be better suited to certain types of business lines and cause banks to shift to those that are more favorable, said some bankers. Others noted that regulatory capital ratios are often used as an indicator of financial health or "badge of soundness" and taken seriously by the markets and rating agencies, so changes from Basel II could indeed affect behavior. Other comments pointed to concerns that Basel II has many layers of conservatism built in, meaning that capital levels under the new framework could be significantly higher than internal economic capital. Finally, there were comments stating that the effects of Basel II remain somewhat shrouded in uncertainty, so calculating their potential impact is not really possible at this time.

In response, staff stated the intention to examine all of these issues more fully and to try to reduce uncertainty about the impact of Basel II as much as possible. Staff solicited specific suggestions from bankers about how best to do this. Staff also made it very clear that they were not interested in a shift in the U.S. banking landscape and that there should remain opportunities for banks of all sizes to prosper. They did note that small and medium-sized banks have for some time remained profitable while operating with substantially higher capital ratios than larger banks.

Staff also gave a presentation on results from the third Quantitative Impact Study, or QIS 3 (see accompanying presentation "QIS Results"), which generated some questions from bankers. For one, bankers asked whether the QIS 3 results are confirmation to supervisors that the Accord is on track. Supervisors responded that they considered the numbers to be "about right," and that it did not appear, in the aggregate, that additional capital would have to be raised under Basel II. In general, for those banks whose QIS results showed an increased need for capital using advanced approaches, it appeared that was justified due to their risk profile. This was consistent with the idea that the increased risk sensitivity under Basel II could lead to higher or lower capital than today for some individual banks, but that the overall level of capital in the banking system should remain about the same. And if a bank were to see a rise in required capital, that would not necessarily be a bad thing, objectively speaking, but could be seen as an improvement in risk sensitivity.

However, staff were quick to point out that QIS 3 results should be interpreted with some care, because QIS 3 banks in the United States conducted this study on a best-efforts basis, and many of them for the first time. In addition, there was no supervisory process to vet the inputs that banks used. Staff acknowledged that they expect to conduct further assessments of quantitative impact to make sure that the calibration is correct going into final implementation. There were some questions about the Advanced Measurement Approach (AMA) for operational risk not being used for QIS 3, and if that meant capital might drop further when banks applied the AMA. Staff responded that, generally, AMA numbers were somewhat consistent with other operational risk charges, but that as banks become more sophisticated with the AMA, they might reduce the cushion embedded in current operational risk measures.

These latest developments regarding CRE were generally well received by bankers, given that most thought as onerous the previous treatment of applying some in-place real estate to the higher risk-weight curve. One banker acknowledged that certain types of speculative CRE should indeed receive somewhat higher treatment, due to particular cyclicality. Staff noted that a white paper on CRE would be available by mid-June, and they encouraged bankers to review it. In particular, staff is looking for additional examples or data sources to provide additional clarity to the CRE framework.

Staff also explained the latest developments in the retail credit framework, including the major revisions made since the second Consultative Paper. Again they encouraged institutions to comment on the proposals during the third consultative paper (CP3) and ANPR comment periods. Staff is particularly interested in areas where the added complexity to provide greater flexibility is perhaps not worthwhile, as well as issues of calibration and potential competitive distortions. A question arose about using different scores for originating credits versus managing them on an ongoing basis. Staff responded that this flexibility was built into the framework. One banker, who generally supported the framework, thought that the treatment for open-to-buy (relating to the undrawn portion) on securitized assets was perhaps not appropriate.

In response to questions about current rules, staff noted that the rules do indeed contain a charge for operational risk, but that it is embedded in the overall charge for credit risk. And banks have been managing operational risk under the current rules for some time. Supervisors pointed to the significant number of large operational losses in recent history as evidence that operational risk is not just a trivial concern. Most large banks with any type of sophisticated economic capital model should be allocating internal capital for operational risk already. The AMA, therefore, is a means to further define operational risk and create an explicit regulatory capital charge for it (the Basel Committee will make sure that there are clear rules about allocating capital to operational versus credit risk, to prevent any mixing between the two). However, since the AMA is most appropriate for the largest, most complex banks, it will not be extended to the current U.S. capital rules. Several bankers claimed that the AMA could hold them back from moving to Basel II, because their systems are not as far along on the operational risk side. Some noted that it is particularly hard to model high-severity/low-probability events (such as Barings) and find an appropriate probability distribution. Others said that such events really cannot be modeled--that they should be avoided by having strong controls. It was also pointed out that subsidiaries of foreign banks may encounter problems with the allocation of AMA capital across legal entities in various countries, because it is generally calculated at the consolidated, global level. Supervisors acknowledged this as an issue and said they would work within the AIG to ease burden and come up with viable solutions.

There is a similar situation with Pillar Three, in that U.S. banks are already disclosing substantially more than banks in most other jurisdictions. One bank pointed out that whatever final form the Pillar Three requirements take, they could become the industry standard of disclosure. There were a number of questions about whether a bank's opting in would constitute a material event and thus would have to be disclosed. Supervisors were not entirely sure that the decision to opt in would constitute a material event--but that actually moving to Basel II certainly would. Bankers were generally concerned about potential disclosures surrounding Basel II, particularly in light of new requirements under the Sarbanes-Oxley Act. Bankers asked supervisors to clarify disclosure rules as much as possible and try to harmonize any differences among various regulations relating to disclosure.

Finally, several bankers expressed concern about possible "trickle-down" effects on overall supervisory standards. That is, even if a bank decides not to adopt Basel II, it might well be held to Basel II-type standards by supervisors. Staff acknowledged that they need to be careful when encouraging better risk management overall so as not to inadvertently apply standards that are inappropriate for a given institution. There is no intentional "stealth effort" by supervisors to actually apply Basel II standards to all institutions, but bankers should immediately raise the issue if they sense it is indeed occurring. Bankers were also worried that local supervisory teams might exert some pressure on non-mandatory banks to become Basel II banks. Keeping supervisory staff informed of the latest developments in Basel II and aligned with the overall implementation strategy is indeed a challenge, noted staff, but strides are being made to ensure this. Importantly, supervisors believe that interagency cooperation has been very effective at maintaining consistency.