The Basel II framework should improve supervisors' ability to understand and monitor the risk taking and capital adequacy of large complex institutions, thereby allowing regulators to address emerging problems more proactively. It should also enhance the ability of market participants, through public disclosures, to evaluate the risk positions at those institutions by providing much better risk measures. The advanced approaches under Basel II, which include the advanced internal ratings-based approach (or A-IRB) for credit risk and the advanced measurement approaches (or AMA) for operational risk, offer particularly good improvements in terms of risk sensitivity, since they incorporate advanced risk-management processes already used today by best-practice institutions.

The emphasis in Basel II on improved data standards should not be interpreted solely as a requirement to determine regulatory capital standards, but rather as a foundation for more advanced risk-management practices that would strengthen the value of the banking franchise. But while the new framework would, in our view, provide useful incentives for institutions to accelerate the improvement of risk management, we believe that in most areas of risk management institutions would continue to have the choice among which methods they employ.

The Federal Reserve considers the agencies' September 30 announcement relating to Basel II a good outcome and an example of successful interagency cooperation. As you may recall, in April of this year the agencies announced jointly their reaction to initial results of a fourth quantitative impact study pertaining to Basel II, known as QIS4. As the April statement indicated, we were concerned about results from QIS4 that showed a wider dispersion and a larger overall drop in minimum regulatory capital requirements for the QIS4 population of institutions than the agencies had initially expected. The initial QIS4 results prompted the agencies to delay issuance of a notice of proposed rulemaking (NPR) for Basel II in order to conduct further analysis of those results and their potential impact. The agencies' reaction to the initial QIS4 results, deciding to take additional time to understand more fully the information provided by the QIS4 institutions, is an indicator of how seriously we are taking Basel II implementation.

Based on the results of QIS4, the Federal Reserve recognizes that all institutions have additional work to do. In our view, the findings did not point to insurmountable problems, but instead identified areas for future supervisory focus. In that way, the analysis was critical in providing comfort to enable us to move forward...While the QIS4 results clearly provided a much better sense than before of the progress in implementing Basel II and offered additional insights about the link between risks and capital, QIS4 should not be considered a complete forecast of Basel II's ultimate effects. It was a point-in-time look at how the U.S. implementation was progressing.

During U.S. implementation of Basel II, if at any stage in the process we see something that concerns the banking agencies, we will reassess and propose amendments to relevant parts of the framework...The Federal Reserve considers all of the planned safeguards and checks and balances to be sufficient for Basel II to be implemented in the United States effectively, and with no negative impact on safety and soundness or the functioning of banking markets. 

Market participants are also expected to play an important role as Basel II is implemented.  Not just supervisors will be expected to evaluate information provided by institutions.  As Basel II rolls out, bankers would be expected to disclose where their institution is in its stages of implementation, how the institution assesses and manages risk, and relevant information for third parties to ascertain the effectiveness of the bank's risk management.

The Federal Reserve has conducted a number of studies on whether Basel II will create significant market distortions for the vast majority of banking organizations that remain on Basel I. These studies have suggested that competitive impacts will be mild for some business lines, while for others, such as some types of small-business loans, it does appear that unintended competitive advantages and disadvantages might be created--depending in part on how Basel II is ultimately implemented in the United States.

We would like to allow the banking community to compare and comment on both proposals, for the very reason that we are sensitive to the potential for competitive distortions. Moreover, as in the past, if competitive or other issues later arise that we cannot now foresee, the Federal Reserve will make appropriate adjustments to the rules.

For the vast majority of banks here in the United States, I see no reason to replace the Basel I-based regulatory framework with a complex framework similar to advanced Basel II.

We expect that Basel II will complement the evolution of banks' own processes and systems, not supplant them...We also anticipate that Basel II will allow for the open development of new risk-management techniques, as they evolve over time.

We need the risk-measurement and risk-management infrastructure and the risk sensitivity of Basel II; but we also need the supplementary assurance of a minimum equity base.

In looking back, I believe Basel I, with its common definitions, common agreement on capital minimums, and the initial risk-weighting categories, has served the banking and financial community well. Indeed, there is no reason to replace Basel I for the vast majority of banks here in the United States. But our largest and most complex global banking organizations have, in a sense, outgrown Basel I.

Basel II is indeed a seminal step in the development of regulatory capital requirements. It is not necessarily the endpoint, but it does represent a substantial step forward--one that we believe will remain in place for many years to come.

We believe that by outlining what supervisors would expect, the proposed guidance gives banks a far better understanding of how to upgrade their systems, modify their procedures, and strengthen their controls in anticipation of eventual adoption of Basel II. Our hope is that, by clearly communicating expectations, we are giving both bankers and our own examiners sufficient time to prepare for the new framework.

Results from [the fourth Quantitative Impact Study] were more widely dispersed and showed a larger overall drop in capital than the agencies had expected. This was the impetus for deciding to delay the notice of proposed rulemaking for Basel II. We now have to determine whether these results arose from actual differences in risk among respondents, differences in stages of preparation (including data limitations) among respondents, limits of the QIS4 exercise, or a possible need for adjustments to the Basel framework itself.