Good afternoon. I am delighted to
be with you today to offer some remarks about financial markets
and about how financial innovation and business practices are
affecting the supervision and regulation of banks. As a result of
the "opportunities" many of you and your colleagues have
provided, we have learned much in recent years about risk
management practices and about market dynamics during periods of
stress.
Today I would like to discuss
three elements of risk management in banks, and more broadly, in
financial services. These topics might be of interest to you
because, I believe, many of you play an important role in the risk
measurement, management and mitigation activities in your firms.
In addition, as barriers between financial firms dissolve, either
because of market action or, as now seems likely, legislative
mandate, we should all learn the risk management techniques that
are current in other segments of the financial services market.
Bankers can and will learn from securities dealers and traders and
vice versa. The topics that I would like to cover are lessons from
last year's turmoil, approaches banks take in measuring market and
credit risk, and proposed changes in regulatory oversight.
Lessons from Last Year's
Turmoil
I would like to begin this afternoon by reviewing some of the
central findings of a study issued this month by the Bank for
International Settlements dealing with market events in the autumn
of last year and then turn to bank supervisory matters. These
findings offer important lessons for all of us who are interested
in maintaining efficient financial markets that are undisturbed by
systemic risks. I would note that the full report, entitled A
Review of Financial Market Events in Autumn 1998, is available
on the BIS website, www.bis.org.
A central point in the paper is
that banks and many other market participants are leveraged
institutions. As a consequence, they are vulnerable when things go
wrong. And so are their creditors, and then their creditors, too.
This use of leverage allows financial institutions to employ
capital in the most efficient and effective ways so as to provide
maximum benefits to our society. When it comes to banks in
particular, the key question is to what degree they should be
leveraged, and that, in turn, depends largely on how they manage
risk. Risk management practices used by both banking and nonbank
organizations have improved significantly in recent years.
Nevertheless, some of these new, innovative techniques, or at
least their application in many firms, were an element of some of
the problems we saw last year.
In particular, "relative
value arbitrage" techniques--in which approximately
offsetting positions are taken in similar, but not identical,
financial instruments--played an important role. Had the
instruments been identical and simply traded in different markets,
the technique would have been one of classic arbitrage and
virtually risk-free. In fact, these positions were not. They were
taken--and taken on an increasingly large scale--because risk
managers were confident that they could measure risks to their
satisfaction using improved techniques and historical data
sources. They were taken with the view that different prices for
similar instruments would eventually converge, providing the
holder with a profit. For a long period of time, the practice
worked remarkably well.
Another important factor was
"proxy hedging," in which traders took positions in
larger, more liquid markets to offset exposures in more thinly
traded markets. Hedging Russian securities with Hungarian or even
Brazilian debt was an example. This risk management practice
enabled traders to conduct more transactions than otherwise
possible, but by its nature, it also tightened links across
markets and altered price dynamics.
The consequences, of course, are
widely known. On the heels of earlier problems in Thailand,
Indonesia, and other Asian countries, Russia's default in August
of last year caused investors worldwide to reassess risks and
their views about conditions in emerging markets. A so-called
"flight to quality" ensued, leaving still more turmoil
in its wake.
What can we learn, then, from
this experience in terms of risk management practices and in
supervising and regulating banks? For one, the world's a dangerous
place. That's hardly news. In terms of financial markets, though,
the experience illustrated quite vividly how closely linked world
markets are today and the types of issues market participants and
policy makers need to consider. Problems in Russia left their
imprint on countries seemingly far removed, including Brazil. They
also brought significant changes at a highly regarded U.S. firm
that was managed, in part, by leading financial market theorists
and practitioners. It was a humbling and enlightening experience
for us all. It should cause all of us to reassess our practices
and our views about the underlying nature of market risks. As the
BIS report makes clear, there are also more detailed lessons to
learn. The report discusses nine lessons; I will pick three:
Measuring Market and Credit
Risk in Banks
Fortunately, progress is being made as banking
organizations--typically the largest U.S. and foreign
institutions--find better ways to quantify their risks. With
market risk--the "easy" one--the Federal Reserve and
other regulators built on industry practices for measuring a
bank's "value at risk" when implementing a new
regulatory capital standard for the banking system last year.
Basing capital requirements on a bank's internal calculations of
its largest expected daily trading loss at a 99 percent confidence
level was an important step, we thought. It produced a standard
far more sensitive to changing levels of risk than was the earlier
approach. It provided a reasonably consistent standard among banks
and also was compatible with current management practice of the
world's more progressive banks. Last year's events have not
changed our view about the merits of this approach.
In creating the standard,
though, we tried to recognize the measure's limitations and to
incorporate sufficient buffers. Everyone recognized the
possibility of large, statistically improbable losses, and that
the measures commonly used underestimated the likelihood of those
events. (We just didn't realize that such extreme outcomes would
occur so soon.) So we required an assumed 10-day holding period,
rather than the conventional single day, in order to account for
illiquid markets, and we multiplied the capital that would result
from that adjustment by three. We also added a charge for
"specific risk" to address issuer defaults and other
matters. And finally, we required a management process that
included crucial checks and balances and further work by banks
toward stress testing, including testing involving scenario
analysis. These were the "qualitative" aspects of the
standard. Results of stress tests, for example, were to be
consider subjectively by management in evaluating a bank's market
risks and overall capital adequacy.
At the time, many of these
elements were criticized as excessive, producing much too large
capital requirements. The jury on that point may still be out, but
at least the standard performed well last year. None of the U.S.
and foreign banks last year that were subject to this internal
models approach incurred losses exceeding its capital requirements
for market risk, although a few came relatively close. On the
other hand, some banks had trading losses that occasionally
exceeded their daily value-at-risk calculations during the
volatile fourth quarter. My point is not that we were so smart in
constructing the standard, but rather that we all still have much
to learn. Risk measurement practices are advancing, and they need
to.
With credit risk, we are all
feeling our way, again with the assistance of many large banks.
Supervisors report that these institutions are making progress in
measuring credit risk and are devoting increased attention and
resources to the task. In my view, continued progress in this area
is fundamentally important on many fronts. Continually declining
costs in collecting, storing, and analyzing historical loss data;
innovative ways to identify default risks, including the use of
equity prices; and greater efforts by banks to build greater risk
differentiation into their internal credit rating processes have
been of great help. As a result, banks are developing better tools
to price credit risk, and they are providing clearer, more
accurate signals and incentives to personnel engaged in managing
and controlling the risk.
Through the Basel Committee on
Banking Supervision, the Federal Reserve and other U.S. and
foreign bank supervisory agencies are working actively to design a
more accurate, risk sensitive capital standard for credit risk
than the one we have now. Full credit risk modeling seems
currently beyond our reach, since industry practices have not
sufficiently evolved. The Basel Committee expects, though, next
year to propose an approach built on internal credit risk ratings
of banks. Such a new standard would be a major step for bank
supervision and regulation and will also have major implications
for banks around the world. It is also a necessary step, we
believe, if we are to keep pace with market practices and address
developments that undermine current standards.
Let me emphasize that the new
credit risk approaches being contemplated will be applicable only
to the larger, more sophisticated and complicated organizations.
The vast majority of banks need not have their capital
requirements modified in significant ways as we move away from a
one-size-fits-all structure.
In order to spur industry
efforts in measuring risk, the Federal Reserve this past summer
issued a new supervisory policy directing examiners to review the
internal credit risk rating systems of large banks. That statement
emphasized the need for banking organizations to ensure their
capital was not only adequate in meeting regulatory standards, but
also that it was sufficient to support all underlying risks. We
issued the guidance recognizing the need to make clear progress in
developing new capital standards and also with the view that the
industry has important steps to take. Our earlier discussions with
major institutions about their own processes for judging their
capital adequacy supported that view. Too often they rely on the
regulatory measure, itself, and on those calculations for their
peers. The role of internal measures of economic risks in
evaluating the level of firm-wide capital seemed generally weak
and unclear. The need for a stronger connection between economic
risks and capital is particularly great at institutions actively
involved in complex securitizations and in other complex transfers
of risk. We do not expect immediate results for most
organizations, but we want to see clear and steady progress made
by them.
The Other "Pillars"
Regulatory capital standards are important, but they are only part
of a complete oversight process. To that point, the Basel
Committee is building its approach on three so-called pillars:
capital standards, supervision, and market discipline. Each pillar
is important and connected with one another. Given the pace of
transactions and the complexity of banking products, the Federal
Reserve and other authorities need to rely increasingly on
internal risk measures, information systems, and internal controls
of banks. As I mentioned above, strong, more risk-sensitive
capital requirements built on a bank's internal model must also be
reviewed periodically for their rigor and effectiveness. With the
varying and somewhat subjective nature of internal measures, the
matter of consistency among banks becomes important, both to banks
and their supervisors. Additional public disclosures by banks and
market discipline can help in that respect.
Bank Supervision. In
supervising banks, U.S. regulators have recognized the need for an
on-going, more risk-focused approach, particularly for large,
complex, and internationally active banks. We constantly need to
stay abreast of the nature of their activities and of their
management and control processes. For these institutions,
point-in-time examinations no longer suffice, and they have not
sufficed for some time. We need assurance that these institutions
will handle routine and non-routine transactions properly long
after examiners leave the bank. We also need to tailor our on-site
reviews to the circumstances and activities at each institution,
so that our time is well spent understanding the bank's management
process and identifying weaknesses in key systems and controls.
Nevertheless, the process still entails a certain amount of
transaction testing.
To accommodate this process, the
Federal Reserve has established a separate supervisory program for
large, complex banking organizations, or LCBOs. We believe theses
institutions require more specialized, ongoing oversight because
of the size and dynamic nature of their activities. The program is
more, though, than simply enhanced supervision of individual
institutions. It involves a broader understanding of the potential
systemic risk represented by this group of institutions.
Currently, there are about thirty institutions in the group,
although the figure can change. They are typically both major
competitors and counterparties of one another and, combined,
account for a substantial share of the systemic risk inherent in
the U.S. banking system.
Management of this process
revolves around a supervisory officer, designated as a
"Central Point of Contact," and a team of experienced
staff members with skills suited to the business activities and
risk profile of each institution. In large part, they will focus
on internal management information systems and procedures for
identifying and controlling risk. They will need to understand the
risk management process as each institution implements it--by
major business line, by type of risk, and so forth--in reaching
overall judgments about corporate-wide risks. We believe this
approach will best help supervisors keep abreast of risks and
events and that it will also help us identify and strengthen weak
areas within banks.
The principal risk in banking
relates, of course, to credit risk arising from lending. For most
of this decade loan portfolios and bank earnings have been strong,
helped largely by persistently strong economic growth. That
performance has strengthened the industry's financial statements
and substantially improved its image with investors. As time has
passed, however, it also may have allowed banks to let
underwriting standards slip in the face of competitive pressures
and the view that times will remain good. We know from history
that they won't. Indeed, recent industry figures suggest the
condition of loan portfolios may be declining as delinquencies
build from admittedly low levels. Through supervisory actions and
guidance, we try to maintain prudent standards throughout the
business cycle.
Market Discipline. Market
discipline has, in my view, two key purposes. The first is to link
banks' funding costs--both debt and equity--more closely to their
risk-taking. This linkage has been more or less weakened by the
safety net. Of course, a significant and growing proportion of the
liabilities of large banks is in an uninsured or not fully insured
form, so that linkage can be reestablished. The cost of these
funds, as well as the banks' cost of equity capital, would clearly
be affected by more disclosure of the risks in their portfolios.
While banks already disclose considerable information, the balance
between quantity and quality can be improved. Doing so should
reduce the need for supervisors to intrude and should also affect
a bank's willingness to take risks, as its funding costs change.
The second purpose of market
discipline is to provide a supplementary source of information to
the examination process. I have been impressed during my service
on the Board as to the wide range of intelligence that our
examination process now creates. But as banking organizations
become more complex we are going to need all the help we can get,
especially if we wish to avoid killing the goose that laid the
golden egg through more intrusive supervision.
Market discipline has some
risks. It cannot be turned off once begun and could present its
own problems during periods of generalized stress by creating
additional pressures that authorities would prefer to avoid. In
short, it can be a mixed blessing. As policymakers, we need to
balance the risk it presents with the benefits it can provide in
curbing excessive risk taking and preventing problems altogether.
Conclusion
In closing, we have seen important gains in risk management
throughout this decade and substantial innovation in financial
markets and products. These changes bode well, I believe, for
distributing risks more efficiently and producing further gains in
economic growth in the years to come. They may also, though,
produce greater market volatility, as more sophisticated
techniques for valuing financial assets identify the winners and
losers with greater speed. We also learned that some of these
techniques, until refined with experience, might also mislead
their users.
All of this presents continued
challenges for central banks and financial supervisors. The best
approach, I believe, is to move with the industry and conform
oversight functions more closely to business practice. Supervisors
can do much in this way to promote sound risk management around
the globe and to provide banks with stronger incentives to manage
and control their risks. It will require functional regulators to
work together and with market participants, too. It will also
require regulators to rely more on market discipline and to ensure
that investors and others have meaningful information about the
level and nature of financial risk. By providing leadership in
reaching agreements about useful disclosures, we also can help
there.
Heavier supervision and
regulation of banks and other financial firms is not a solution,
despite the size of some institutions today and their potential
for contributing to systemic risk. Increased oversight can
undermine market discipline and contribute to moral hazard. Less
reliance on governments and more on market forces is the key to
preparing the financial system for the next millennium.
Thank you.
