Basel III is not a perfect agreement, of course. There are things we would have done differently if we were writing a capital regulation on our own... But it is a major step forward for capital regulation. It will raise minimum requirements substantially, ensure that regulatory capital is truly loss absorbing, and discourage some of the risky activities for which the pre-crisis regime required far too little capital.

In the United States we have as a first line of defense we have a risk weighted capital ratio which is not a straight leverage ratio, it's an amount of capital we have to hold against assets where we have to hold more capital against riskier assets, which makes sense. The risk of the asset, the more capital you want to hold and we are, we the Federal Reserve and the other bank regulators are working very actively with other regulators around the world to strengthen the capital requirements. We've already made proposals to do that. We are going to get assessments from the banks about how big an impact that would have. And it's our intention to move forward with more conservative higher capital requirements. So that's the first thing.

The leverage ratio is kind of a back stop, a fail safe if you will, because it's a very simple ratio, it's just a ratio of capital against total assets without making much or any distinction between Treasury's versus loans to small businesses for example. And the United States has long had a leverage ratio as a backstop to our capital rules.

One of the interesting things that appears to be coming out of the international negotiations is that the U.S. leverage ratio, which never was used abroad now looks like it will be adopted by other countries as well, which is good for us because it'll create a more even playing field and create greater safety in the global banking system as well as here.

So the leverage ratio is part of these negotiations and discussions we're having internationally and there are proposals on the table. We haven't yet gone through the whole process of doing the quantitative analysis to figure out exactly what the right number is, so I can't tell you off hand you know what the final number will be, but we're certainly looking to make the leverage ratio part of the more conservative approach to making sure that banks have enough capital that they can absorb even in a severe crisis like one we've had they can absorb their losses.
So yes, that will be part of our proposal.

The intense public debate over Basel II seems like a thing of the distant past. And maybe that's understandable with everything else going on in the world. But when we emerge from this crisis, a top priority must be crafting a sound capital framework that helps avoid a repeat of past problems.

So, where do we stand? I still have grave concerns about the advanced approach. The advanced approach assumes banks' internal, quantitative risk estimates are reliable. It also assumes the loss correlations we measured during good times ... which is the backbone of the whole approach ... will hold up in the future.

To say the assumptions turned out to be wrong would be an understatement. They were way wrong in estimating risk. The Basel Committee is changing the rules in a number of areas. These will be improvements. But for most banks, they are unlikely to offset what we see as a capital-lowering bias that is essentially baked into the advanced approach.

A Moody's report in December gives some recent evidence. It looked at Basel II implementation outside the U.S. And it said that almost all the banks using advanced methodologies reported a reduction in risk weighted assets, in many cases material reductions.

So if the advanced approach says banks need less capital at the height of a global banking crisis, imagine the financial leverage it would encourage during good times.

As market participants take steps to foster greater transparency and to reduce the complexity of structured credit instruments, I believe that recovery and repair in the mortgage markets will take hold over time. Moreover, as financial institutions strengthen risk-management practices and as supervisors ensure that the necessary actions are taken, I expect the financial system as a whole to become more resilient.  

Events of the past year have shown that institutions should never let their guard down when it comes to risk management.  Even though most of the high-profile losses during the past year have--so far--stemmed from market and credit risks, one should not, therefore, assume that less attention should be paid to operational risk management.  The Basel II capital framework is a positive step forward through its combination of more risk-sensitive capital requirements with strong incentives for improved risk management.  In this manner, we expect Basel II to make the U.S. banking industry more resilient in the face of future financial turbulence and generally more safe and sound.     

The provision of liquidity by a central bank can help mitigate a financial crisis. However, central banks face a tradeoff when deciding to provide extraordinary liquidity support. A central bank that is too quick to act as liquidity provider of last resort risks inducing moral hazard; specifically, if market participants come to believe that the Federal Reserve or other central banks will take such measures whenever financial stress develops, financial institutions and their creditors would have less incentive to pursue suitable strategies for managing liquidity risk and more incentive to take such risks.

Although central banks should give careful consideration to their criteria for invoking extraordinary liquidity measures, the problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis. Recall Bagehot's advice: "The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times" (p. 24). Indeed, under the international Basel II capital accord, supervisors are expected to require that institutions have adequate processes in place to measure and manage risk, importantly including liquidity risk. In light of the recent experience, and following the recommendations of the President's Working Group on Financial Markets (2008), the Federal Reserve and other supervisors are reviewing their policies and guidance regarding liquidity risk management to determine what improvements can be made. In particular, future liquidity planning will have to take into account the possibility of a sudden loss of substantial amounts of secured financing. Of course, even the most carefully crafted regulations cannot ensure that liquidity crises will not happen again. But, if moral hazard is effectively mitigated, and if financial institutions and investors draw appropriate lessons from the recent experience about the need for strong liquidity risk management practices, the frequency and severity of future crises should be significantly reduced.

At the Federal Reserve and at other bank regulatory agencies, our job is to reinforce the incentives and actions that are building a more resilient financial system. We need to make sure that regulatory minimum capital requirements and liquidity management plans protect reasonably well against shocks becoming systemic. Our supervisory guidance needs to be in place to prevent backsliding when, over the coming years, the memories and lessons of the current market turmoil fade, as they certainly will.

To these ends, we are reexamining a host of things ranging from Basel II to liquidity to transparency. Working with our domestic and international colleagues, we are looking to raise the Basel II capital requirements on specific exposures that have been troublesome, such as super senior CDOs of asset-backed securities and off-balance-sheet commitments. We are looking to the Basel Committee on Banking Supervision to update its guidance on liquidity management in light of the recent experience. And we and our supervisory colleagues are looking to require better disclosures of off-balance-sheet commitments and of valuations of complex structured products.

The rating agencies did a good job on the plain vanilla type of ratings. That was not the problem. 

There were these securities which people were using that were using very complicated financial engineering, and very complicated legal documents, to basically, supposedly, decrease risk by diversification.

It turns out that people then realized that the rating agencies were not able to rate these things properly.  There is obviously now a recognition that depending completely on rating agencies without doing due diligence yourself may be problematic.'

From the audience Q&A as reported by Bloomberg News

Recent market events highlight why a robust and independent assessment of risk on the part of banks is so important. The enhanced risk-sensitivity of the Basel II advanced approaches creates positive incentives for banks to lend to more-creditworthy counterparties and to lend against good collateral, by requiring banks to hold more capital against higher-risk exposures.  

The simple risk-bucketing approach in the existing Basel I rule, for example, creates perverse incentives for risk-taking. This approach--in which (1) the same amount of regulatory capital is assessed against all unsecured corporate loans and bonds regardless of actual risk, (2) all unsecured consumer credit card exposures are treated equivalently, and (3) almost all first-lien residential mortgage exposures are deemed equally risky--provides incentives for banking organizations to shed relatively low-risk exposures and acquire relatively high-risk exposures within each of these asset classes. The existing Basel I rule also ignores important elements of credit-risk mitigation--such as most forms of collateral, many guarantees and credit derivatives, and the maturity and seniority of an exposure--and thus blunts bank incentives to reduce or otherwise manage risk.

On balance, the Federal Reserve believes that an appropriately conservative approach to capital adequacy serves the United States' interest in maintaining the safety, soundness, and resiliency of our banking system.  However, we also recognize the impact that differences among countries can have and that it is worthwhile to minimize them whenever possible.  As Chairman Bernanke noted this past fall, we intend to review and consider international differences before issuing a final Basel II rule.    

One result of this changing financial environment is to make a risk-based approach to capital requirements more essential, particularly as countries deregulate their financial markets and remove provisions that once served to limit risk taking.

A key aspect of Basel II implementation in the United States relates to scope of application. In the United States, Basel II is expected to apply to only a handful of large, complex organizations, which is the principal reason why the U.S. agencies are proposing only the advanced approaches (A-IRB for credit risk and AMA for operational risk). Perhaps the main difference between the implementation of Basel II in the United States and the implementation in most other countries is that the U.S. banking agencies plan to retain a revised form of the existing Basel I-based capital rules for the vast majority of U.S. banks; most other countries are replacing Basel I entirely and will apply Basel II to the entire banking system.

As noted, we anticipate that only one to two dozen institutions would move to the U.S. version of Basel II in the near term, meaning that the vast majority of U.S. institutions would continue to operate under Basel I-based rules. The U.S. Basel I framework has already been amended more than twenty-five times since its introduction, in response to changes in banking products and the financial services marketplace. In October 2005, the agencies issued an ANPR for Basel IA, which discussed possible changes to increase the risk sensitivity of the U.S. Basel I rules and to mitigate competitive distortions that might be created by introducing Basel II.

We have also been working to promote a level playing field internationally for U.S. banking organizations that adopt Basel II. Indeed, maintaining competitive equity was one of our key motivations for developing Basel II jointly with foreign supervisors through the Basel Committee. More recently, we have been working through the Basel Committee's Accord Implementation Group to mitigate home-host conflicts while promoting consistent implementation of Basel II internationally.

Despite these efforts, some significant differences do exist between the United States and other countries in the proposed implementation of Basel II's advanced approaches, beyond the transitional safeguards. Early comments on the Basel II NPR suggest that, whatever the merits of these international differences in rules, they are likely to add to implementation costs and home-host issues, particularly for globally active banks operating in multiple jurisdictions. Before we issue a final rule, we intend to review all international differences to assess whether the benefits of rules specific to the United States outweigh the costs. In particular, we will look carefully at differences in the implementation of Basel II that may adversely affect the international competitiveness of U.S. banks.