Naturally, we must also ensure that our regulations and supervisory oversight are in tune with bank practice, are able to identify the risks being taken by banks today, and have enough flexibility that they will continue to be prudent and relevant in an ever-changing risk environment. As Chairman Bernanke has noted, a regulatory and supervisory system that is not in tune with the financial marketplace may increase the costs of regulation, stifle efficiency and innovation, and ultimately be less effective in mitigating the moral hazard problems associated with the federal safety net.

A key mechanism in Basel II for balancing the inevitable tensions that arise when attempting to achieve sometimes competing objectives is the so-called use test. Under the use test, the systems and processes that a bank uses for regulatory capital purposes must be consistent with those used internally. Note that I use the word "consistent," not "identical."

Let me assure you that we at the Federal Reserve would not be pursuing Basel II if we thought that it would in any way undermine the strong capital base that U.S. institutions now have. As a central bank and a supervisor of banks, bank holdings companies, and financial holding companies, the Federal Reserve is committed to ensuring that the Basel II framework delivers a strong and risk-sensitive base of capital for our largest and most complex banking institutions.

This means that during and after the transition to Basel II, supervisors will rely upon ongoing, detailed analysis to continuously evaluate the results of the new framework and ensure prudent levels of capital. To be quite clear, the Federal Reserve believes that strong capital is critical to the health of our banking system and we believe that Basel II will help us continue to ensure that U.S. banks maintain capital levels that serve as an appropriate cushion against risk-taking.

In addition to enhancing the meaningfulness of regulatory capital measures, Basel II should make the financial system safer by substantially improving risk management at banks.

As the central bank and the supervisor of banks, bank holding companies, and financial holding companies, the Federal Reserve is committed to ensuring that the Basel II framework delivers a strong and risk-sensitive base of capital.

We think Basel II is very important because it will allow banks' capital holdings to be sensitive to the risks that they take, and that will be consistent with modern risk management techniques, so we think it's important to move forward with Basel II. But we don't see this as - we certainly don't want this to be the source of a significant reduction in aggregate capital in the U.S. banking system.

One of the questions regulators have been asked as we work toward implementing Basel II is whether we can just continue to encourage the improvement in risk modeling at banks and stop there, i.e., not tie risk models to capital. While improvements in the methodology of risk models and the transparency of better risk modeling in business decisionmaking are very useful, I believe we cannot stop there...For safety and soundness reasons, bank supervisors must be sure that a bank with greater exposure to riskier lines of business, products, and customers holds more capital than a bank that is more risk adverse and designs its business plan to minimize risk taking. That is, just looking at risk models and not tying capital to the measured risk exposures does not provide the backstop that supervisors need to ensure that each institution has the appropriate capital in place before the unexpected loss occurs. Capital should be based on risk exposures, and the evolving risk modeling methodologies provide improved tools to better determine the appropriate level of capital. 

Basel II, by tying regulatory capital to bank inputs, offers greater transparency about what stands behind the inputs provided by banks and exactly how they are calculated...Successful institutions understand that calculating internal capital measures is a serious and challenging undertaking, with many moving parts. Supervisors, through their analysis of bank inputs to Basel II, will develop an even better assessment of institutions’ risk-measurement and risk-management practices. Furthermore, the added transparency in Pillar 3 disclosures is expected to provide market participants with a better understanding of an institution’s risks and its ability to manage them.  Perhaps most importantly, Basel II’s advanced approaches create a link between regulatory capital and risk management. Under these approaches, banks will be required to adopt more formal, quantitative risk-measurement and risk-management procedures and processes.

We recognize that some may have concerns about the recent announcement by the U.S. agencies to implement Basel II with a one-year delay and with an extra year of transitional floors. Understandably, internationally active organizations may worry that cross-border implementation will be complicated by the timing differences between the United States and other Basel member countries. While not downplaying potential challenges, the U.S. agencies, in deciding to adjust implementation plans, thought it was important to ensure that implementation in the United States be conducted in a prudential manner and without generating competitive inequalities in our banking markets...As we did before our September 30 announcement of altered U.S. implementation plans, the U.S. banking agencies continue to work with institutions and foreign supervisors to minimize the difficulties in cross-border implementation.

Basel II provides a means for regulators to rely more on banks' internal estimates of risks--but only if those estimates meet certain supervisory standards. Our expectation is that Basel II will also promote further enhancements to risk management. Accordingly, the Federal Reserve considers Basel II to be a worthwhile undertaking and we look forward to its implementation.

Basel II or something like it appears necessary. The banking system has become financially extraordinarily sophisticated. Basel I is no longer sufficient as a means of determining adequate regulatory capital for the banking system.

The Federal Reserve, the other banking regulators, international counter-parties have worked for a number of years trying to determine an appropriate system that would appropriately account for the complexity of the banking system. Basel II tries to embody the notion that the amount of regulatory capital should be based on modern risk- management techniques, which try to evaluate the risks associated with different kinds of investments.

There have been two major developments within the past six weeks regarding U.S. regulatory capital requirements that apply to banking institutions. First, on September 30, the U.S. banking agencies announced their revised plan for the implementation of the Basel II framework in the United States. Second, the agencies published for comment an advance notice of proposed rulemaking (ANPR) pertaining to amendments to the existing Basel I-based capital rules (the amended Basel I). Taken together, these proposals on Basel II and the amended Basel I represent substantial revisions to the regulatory risk-based capital rules applied to U.S. banking institutions, from the very largest to the smallest. From the Federal Reserve's perspective, these two initiatives, when implemented successfully, should produce a much-improved regulatory capital regime in the United States that enhances safety and soundness.

While the current Basel I-based rules have served us well for nearly two decades, they are simply not appropriate for identifying and measuring the risks of our largest, most complex banking organizations. Basel I, even when periodically amended, must be straightforward enough for even the smallest banking organizations to implement with relative ease. Thus, the categories of risk used to determine capital are very broad and are intended to capture the "average" risk levels across the banking system for that generic exposure.

While the balance sheet focus of Basel I is appropriate for most banking organizations, the largest organizations have significant exposures off the books, and these risk exposures need to be considered explicitly in determining minimum regulatory capital for these sophisticated organizations.