Remarks by

John D. Hawke, Jr.

Comptroller of the Currency

before the

International Monetary Conference

June 8, 1999

Philadelphia, Pennsylvania

## Introduction

Few would disagree that the financial world has changed substantially
since the Basel Committee on Banking Supervision promulgated the Capital
Accord in 1988. Internationally-active banks today are significantly
more complex, more driven by technology, and more global in their scope.
Clearly, for these more sophisticated banks, a "one-size-fits-all"
approach to capital is no longer appropriate. Instead, we must find new
ways to reflect credit risks in the capital framework. The Basel
Committee has taken the first step in this direction by recently issuing
a consultative paper looking toward a revision of the Accord.

Today, I will focus my remarks on the issues raised by the 1988 Accord
and the options we at the OCC see for the future of the regulatory
capital framework, in light of the new Basel Committee proposal.

## I. Deconstructing the 1988 Accord

In retrospect, there is no question that the 1988 Accord represented a
significant step forward on several fronts. It has been credited with
reducing international disparities in the regulation of capital
adequacy, addressing the risks posed by the growth of off-balance sheet
instruments, making banks\' capital levels more transparent to market
participants, and reversing what had been a prolonged decline in the
capital levels of internationally active banks. However, as institutions
have grown in complexity and have increasingly resorted to the use of
sophisticated financial tools such as securitization and complex
derivatives to reduce capital requirements, manage risk and allocate
credit, the limitations of the Accord have become manifest. Many of the
limitations of the current Accord are already well recognized. One
fundamental problem is that the current system does not adequately or
accurately assess risk. The current "risk bucketing" approach, under
which assets are sorted into different buckets based on broad categories
of risk, is a crude approach to allocating capital. It has resulted in a
poor differentiation of credit risks, given rise to tremendous arbitrage
opportunities, and led to distortions in the way that banks allocate
credit and price products.

Moreover, the current system does not take into account some of the
common risk management techniques used by banks today, including
diversification and hedging. Although these techniques have helped
bankers to better manage risks, the regulatory capital framework has not
been adjusted to reflect these improvements. Nor has it been adjusted to
take account of the additional risks that stem from concentrations and
other broader "portfolio effects."

Finally, the Accord has not kept pace with developments in risk
management and capital allocation in the banking industry. It has become
increasingly difficult to fit many new product offerings into the
existing risk buckets\--credit derivatives being a prime example. The
inability of the Accord to stay abreast of market innovations has become
one of the main reasons the Basel Committee is looking toward a
substantial revision of the Accord.

Given the problems posed by the current system, our goal *and* our
challenge is to develop a system that is flexible and forward-looking,
and that provides for a useful and rational assessment of risk upon
which to base a capital charge.

## II. What a Revised Accord Offers

The first step toward meeting that goal was taken last week with the
release of the Basel Committee's consultative paper describing elements
for a new capital framework. This paper represents the first step in a
two-step process: first, the development of the framework for the future
Accord; second, the articulation of the details. In each case, industry
comment will be sought, and this is an opportunity that the industry
should grasp. Ultimately, the views of the industry will be of critical
importance to the framing of any future Accord. The Committee has made
it clear that it wants capital rules that reflect not only the risks,
but also the realities of banking today.

The new proposal will seek to update the 1988 Accord in a number of
different areas. First, the proposal would expand the "standardized" or
risk bucketing approach. Second, it looks to the use of new approaches
to measuring credit risk, such as internal ratings. Third, it raises the
issue of what other areas need to be covered by a revised Accord.

Among the fundamental changes that the proposal would make is the
introduction of the "three pillars" of capital. To date, the Accord has
looked primarily at the quantitative aspects of capital. The new Accord
will add two new "pillars" as integral parts of the regulatory capital
framework: supervisory review and market discipline.

The OCC has long believed that supervisory review and market discipline
are important elements in the review of capital adequacy. However, this
is not a view that is held around the world. Qualitative elements tend
to be forgotten when viewed alongside the challenges posed by
quantitative measures such as internal ratings and credit risk modeling.
While most supervisors have ways to implement and enforce capital
adequacy standards, there is now a need to enhance the role that
supervision plays in assessing the qualitative aspects of capital and
identifying the specific methods by which to do so. Market discipline
must also play a role in any capital adequacy framework, as it rewards
banks that manage risks effectively and penalizes those whose risk
management is less prudent. Greater transparency will improve the
market's ability to make rational judgments about an institution's risk
management and overall soundness.

Another change is the proposal for the addition of a capital charge for
"other" risks, such as operational risk and interest rate risk.

The main issue here is how to arrive at an appropriate capital charge.
These "other" risks are not easily quantifiable. Even interest rate
risk, while measurable, is not measured in a consistent way among banks
or countries. The charge for "other" risks will be the source of much
discussion within the Basel Committee, and, I expect, within the banking
community, over the coming months. The third major change addresses the
most serious shortcoming of the present Accord\--the need to make the
credit risk measurement criteria more sensitive to actual risk.

## 

## III. The Future Methodologies

Four approaches to credit risk measurement have been suggested:
expansion of risk buckets; use of external ratings; use of internal
ratings; and portfolio credit risk modeling.

Expanded risk bucketing would not, in my view, be a major step forward
or an option we should pursue avidly in the future. While it offers some
opportunities for refinement, it would perpetuate some of the problems
of the present Accord\--lumping assets that inevitably have differing
risk characteristics into fixed categories, with attendant opportunities
for arbitrage.

A second approach, the use of external ratings from widely recognized
rating agencies, could be applied to both sovereign and corporate
credits. However, there are still some issues that must be thought
through before this approach could be used. For sovereign credits, there
are currently only two risk buckets, one for sovereigns that are members
of the Organization for Economic Cooperation and Development; another
for those who are not. While there is wide agreement that the present
framework for rating sovereigns should be dismantled, the track record
of the rating agencies on sovereign credits has proved disappointing. We
have seen during the Asian crisis of the past two years that ratings
were often lagging indicators of emerging problems. The use of external
ratings also presents some problems for corporate credits. The fact is
that there are generally very few externally rated credits on the books
of most U.S. banks, and outside of the United States the use of external
ratings is much less common than in the US. While external ratings may
prove useful as a part of a broader package, particularly as they become
more common abroad, I do not believe that the external ratings approach
alone will go very far in solving the problems of the current Accord.

The other two approaches raised in the proposal\--internal ratings and,
over the longer term, full portfolio credit risk modeling\--offer the
greatest promise for the most sophisticated internationally-active
banks. But given the current state of the art of these methodologies, it
is questionable whether they will be feasible options in the near term.

The internal ratings approach is geared toward basing a capital charge
on the ratings that banks themselves assign to the credits in their
portfolios. Full portfolio credit risk modeling goes a step further,
using the internal risk ratings as a starting point and then applying
sophisticated modeling techniques to adjust the ratings for "portfolio
effects" to arrive at a capital charge for the entire portfolio.
Advances are being made in both of these methodologies by many
institutions. However, there are still a number of difficulties to work
out before either of these approaches can be reliably used.

Two major challenges posed by the internal risk ratings approach are the
lack of consistency among the internal ratings systems, and the need to
"map" internal ratings to a uniform schedule of capital charges. Systems
developed by individual banks can differ in a number of very important
ways. For example, some institutions may define the credit risk
attributable to "default" as the probability that a loan will go bad,
while others may go further and derive a loss figure that would result
if the credit becomes a problem, the so-called "loss given default."
These inconsistencies compound the problem of translating internal
ratings into a generally applicable range of risk weightings. Of course,
moral hazard must also be considered in connection with any methodology
that attaches significant economic consequences to a bank's own
classification of its risks.

Despite the issues raised by the internal ratings approach, it is still
far closer to implementation than portfolio credit risk modeling, where
challenges are much more difficult to overcome. A recent Basel Committee
report highlighted two substantial difficulties with the current state
of credit risk modeling\--a lack of data and the inability to validate
the models. As I noted, this approach has promise, but we are still a
number of years away from being able to depend comfortably on credit
risk models.

The good news is that many of you in this audience are devoting
significant resources to the development of systems that can overcome
the difficulties that I have just described. I see this process as a
continuing, collaborative effort between the public and private sector.

IV\. [Conclusion]{.underline}

The effort to amend the Accord in a way that both addresses problems
already recognized and takes account of emerging technologies of risk
assessment has substantial momentum behind it. The process will take
some time to complete, but that is desirable for a number of reasons.

As time passes, we will continue to see advances in credit risk
measurement methodologies that will allow for a more precise calculation
of the risks against which capital should be held. Despite the
challenges that must be overcome, the internal ratings approach and,
further down the road, portfolio modeling, offer the most promise for
the future. At the same time that these new methodologies are being
developed, the focus on qualitative approaches to capital, namely
supervisory review and market discipline, will sharpen. Together, these
elements will allow for a more supportable determination of capital
adequacy, while retaining the flexibility to adapt to the changes\--in
risk management and in products and services offered by the banking
community\--that are inevitable in the future.

Thank you.