The capital held by U.S. banks is currently subject to regulation under a framework established by G10 countries in 1988 and enhanced considerably in the U.S. since then. These "Basel I" standards specify the amount of capital that must be held against assets of varying types and risks.

This system is simple and has served us well. But there are structural weaknesses. It ignores the superior information about bank risk embodied in the risk-management models of the largest banks. If supervisors could better harness this information, then the capital requirement for each institution could be more closely tailored to the particular assets it holds. This is the "perfect world" we are trying to capture in the latest round of negotiations on capital – commonly referred to as Basel II.

The Basel II proposals will only apply to the large, complex, and internationally active institutions in the United States. This agreement could well result in a significant reduction in risk-based capital requirements for these banking organizations. This result will be the product of some very sophisticated risk-management techniques, but we believe the role of capital is broader than that. Capital aligns the interests of the insurer and the managers and owners of the insured bank. Capital also compensates for errors in the capital models themselves. And, finally, capital provides an indispensable cushion against unexpected events and unanticipated shifts in the marketplace.

The FDIC and other regulators in the U.S. and in the G-10 recently finalized a draft of the proposed agreement. We will run a test for domestic Basel-eligible banks later this year and will gain from this a better understanding of the proposal's impact on regulatory capital for these institutions. Following any calibrations, the regulators hope to proceed to a domestic rulemaking in 2005 and 2006, with implementation by year-end 2007.