Mr McDonough discusses the changing nature of banking, risk and capital regulation  (Central Bank Articles and Speeches, 17 Mar 1999)
Central bank: fed | Type: speech | Date: 1999-03-17

## Mr McDonough discusses the changing nature of banking, risk and capital regulationSpeech

by the President of the Federal Reserve Bank of New York, Mr William McDonough, at the 29 th Annual Banking Symposium, Bank and Financial Analysts Association, New York City, on 17 March 1999.Good afternoon.

I am pleased to be here today to discuss the changing nature of bank and capital regulation.

With the new millennium on the horizon, it seems a particula time to discuss some of the key trends that are affecting the way both bankers and s think about these issues.

Also, as I'm sure many of you are aware, the Basle Commi Banking Supervision currently is engaged in a fundamental review of the Accord, which cornerstone of existing capital standards.

In many ways, the changing nature of ban its risks have led supervisors to revisit the current capital framework, and so I opportunity to provide my perspective on these risks and how they relate to the capital regulation more generally.In the last several years, we have witnessed an increase in the diversity and com businesses in which banks are engaged.

While lending and deposit-taking are st mainstays for a majority of commercial banks, many banks have grown their deriva trading, securities underwriting and corporate advisory businesses.

Some banks expanded their traditional credit product lines to include asset securitizations derivatives.

Still other banks have greatly increased their transaction processing, asset management businesses, in the pursuit of fee income.Looking forward to the next century, I believe we will see major strides in the suggest we call 'e-finance'.

More banks will venture into the relatively new world PC banking or will expand electronic bill presentment and paying services.

Banks motivated to overcome obstacles such as systems incompatibility and consumer pr concerns, to achieve greater operating efficiencies and to protect their valuabl franchise.

Going forward, on-line purchases and sales of securities by individuals continue to increase, producing a growing source of commissions for financial instituFor most banks, these developments will mean a further increase in the divers complexity of risks to which they are exposed, including, but not limited to, credit, operational risks.

The challenge for these banks will be to develop risk management that are rigorous and comprehensive, yet flexible enough to address the newer risks on as they expand into less familiar product areas.

Today, I would like to highlight and focus on how important it is for banks to integrate their risk management an planning processes.

Also, I would like to focus on how the changing nature of ba challenging supervisors to rethink their approach to capital regulation and supervisiDespite changes in banking over the last few years, many of which already have discussed today, credit risk remains the predominant risk for most banks.

However, c clearly extends beyond conventional credit products such as loans and letters of cre banks are taking on credit risk in the form of margin lending and transactions in th counter derivatives markets that expose them to large amounts of counterparty risk a difficult to measure.

They also may be engaged in taking on credit risk in its m forms.

The short-term credit risks in futures brokerage, where the clearing brok between the customer and the exchange, or the often underestimated, but substantiarisks that arise in settling foreign exchange contracts, are examples.

Credit risk also m in more complicated, less conventional forms, such as credit derivatives or tranche securitized assets.Market risk also remains prominent.

The upheavals in both global fixed income and equiti markets over the last year led to a great deal of volatility in spreads and asset pr caused large swings in bank profitability.

These events demonstrate that the world doe necessarily work the way we thought it did, that there are correlations between markets we had previously thought were unrelated.

As banks continue to expand their global trad operations, the need to understand the relationships between markets increases.

This chal is amplified by technological advances and financial product innovations that contribu ever-more complex market instruments.But clearly, banks are exposed to more than just credit and market risk.

Operational ris is a growing concern for the banking industry.

The looming issue of Year 2000 remediation just one example.

With the continuing diversification of banking, the fast pace of fin innovation and the growing concentration of crucial payments, settlements and custo businesses, the importance of operational risk is rising, especially at many larger inst These institutions find that the probability of a financial loss resulting from a break internal controls or systems is greater than ever.

As banks expand into new lines of bus such as electronic banking, this trend is likely to continue.

For instance, consider the breach in electronic security controls that leads to unauthorized access to confid customer information.

Should this breach be severe and pervasive, it could lead considerable legal and reputational problems for a bank.

Further, the overall rapid pa technological change in this area means there is a substantial risk of obsolescence.These are just some of the risks that banks must manage, and clearly the list I have set not exhaustive.

In particular, consider banks in emerging market countries that are subje unique set of risks as a result of the financing and investment cycles in their countrie banks that fund their domestic assets with foreign currencies may be particularly suscep to liquidity risk when sharp fluctuations in exchange rates and market turbulence mak difficult to retain sources of financing.While I have presented to you some of the major risks as separate and discrete, we rece have discovered that they are, in fact, inter-related.

For instance, we have seen that ma frequently drives credit risk.

In the second half of last year, we saw turbulence in income markets produce severe liquidity and solvency risks for hedge fund market participants.

Also, we have learned that credit risk may derive from operational r embedded in complex systems for managing collateral or intra-day funding, both of whic require rigorous internal control environments.Regardless of the nature or form of risk, the best way for all banks to protect themselv identify risk correctly, accurately measure and price it, appropriately control it and high levels of reserves and capital, in both good times and bad.

However, many banks are finding it easy to develop a holistic approach to assessing and managing the many in related risks they face.

A particular challenge is to relate such risk assessments to ap capital levels, especially given the dynamic nature of their businesses.Before I discuss how some banks are tackling this issue, let me first consider t capital more generally and how it relates to risk and strategy.Fundamentally, the role of capital is to act as a buffer against unidentified, ev remote losses that a bank may incur in the future.

A bank must hold enough capital t both depositors and senior lenders against losses, while leaving the bank able to needs of its customers.

Banks must maintain capital commensurate with the amount of that they take and hold enough to weather financial storms, which can at times be s of considerable duration.

Banks with low equity capital ratios and a high vari operating earnings have proven particularly vulnerable to financial distress.However, banks do not just hold capital to overcome distress, but also because it them with financial flexibility.

Banks that are strongly capitalized can take ad growth opportunities.

Also, strongly capitalized banks are better able to promote i whether in the form of new products, new services or new distribution channels.

Th just a capital resource issue, but a human resource issue.

Bank managers who are able on the business of banking, strategy and competition, rather than on financial diffi create and innovate and, therefore, add value for shareholders.Banks also hold capital as a sign of strength to their customers.

Clearly we know true with depositors on the retail side, but it is equally true on the wholesale s institution or corporation enters into letter of credit guarantees or swap contract be confident that its bank will be around in three or five years, at the maturity of A bank that is well capitalized can credibly state to its customers and clients tha good on its promise to pay.

More and more, clients recognize this and differentia various banks on this basis.

As financial services converge and competitive p increase, banks find that they must vie for capital, not only with their domestic counterparts, but also with investment funds, asset management firms, investment ba insurance companies.This is equally true for emerging market banks that find they must compete internationally active banks in what were previously thought to be solely domestic These banks recognize that an adequately capitalized institution is a necessary sufficient, condition to compete globally and to attract international funds and cl be a challenge for these banks, and particularly those with high-risk profiles a financial statements, to prove to clients, counterparties and stakeholders tha operating safely and soundly.In the face of increasing competitive pressures, banks are focusing more of their a the role of capital, capital levels and targets, and how they relate to strateg objectives.

Many banks also are spending more time assessing their own risk profi evaluating the amount of capital they need to cope with adverse outcomes in normal ti under reasonable stress scenarios.

The more sophisticated banks are in the pr developing internal systems and methodologies, including formal analytical model enable them to do this better.

Some of these banks rely on capital allocation meth typically used for pricing and performance measurement across business and product l a basis for their analysis.

These methodologies frequently incorporate different volatility-based measures that include a view of unexpected loss, along with more s measures of risk.

While many of these systems and methodologies are still in their eaand require refinement, I am encouraged by their development, and hope that the assessme of capital adequacy will continue to be a primary focus of risk management at banki institutions.The senior management of banks can take this further by evaluating not only the adequacy their current capital levels, but also the appropriateness of their capital structure.

I analysis would lead to a process that integrates decisions about business strategy, risk and future capital needs.As banks become better at identifying and quantifying their risks, they should be positioned to enhance risk disclosures and inform investors more fully.

While bank inves ultimately bear the risks of the institution, too frequently they are not in a good po make knowledgeable business decisions about a bank's prospects.

Certainly, investors are well informed than bank management.

In many countries, accounting and disclosure standard do not provide users of financial statements with the necessary information to appropri assess risks and determine soundness.

A lack of transparency discourages capital fr flowing efficiently and, in effect, reduces or even destroys value.However, on a positive note, I am encouraged by progress in numerous countries to promot disclosure and transparency, for instance with regard to non-performing loans.

The Ba Committee on Banking Supervision, the Committee on the Global Financial System, the International Accounting Standards Committee and other organizations have put fort initiatives to enhance the relevance, reliability and comparability of information discl the financial sector.

The most important initiatives will be those of national governme apply these accounting and transparency frameworks, as well as the voluntary disclosures financial institutions.Now that I have discussed the changing risk environment and how banks are responding t that challenge, let me turn to what this means for the current regulatory capital regime.Today, a major challenge for regulators is to develop capital standards that address comprehensively the full range of risks to which banking institutions are exposed.

T standards must also improve the differentiation among high-risk and low-risk exposures a between weak and strong institutions.

Additionally, they must be flexible enough accommodate the risks of newer and emerging activities, some that I have mentioned today.As you know, the primary tool of capital regulation currently is the set of minimum ca ratios that were devised in 1988 by the Basle Committee on Banking Supervision.

They wer set forth in an agreement known as the Basle Accord, and were adopted, among other reason to address the slide in international capital levels that was occurring over a decade ago these ratios were relatively basic, they have proved very effective at achieving their g the last decade.Over the years, risk management approaches have evolved rapidly, while the Basle Accor has evolved relatively slowly.

As market risk management techniques developed, we were able to incorporate a state-of-the-art value-at-risk approach, in a 1996 Market Amendment.

As credit risk management techniques have advanced, and as a new discipline of operational risk has emerged, it has become apparent that the long-run relevance and eff of the Basle Accord is waning for the most sophisticated institutions.Supervisors have long known that analyzing simple capital ratios in isolation ca incorrect conclusions about the relative strengths of institutions.

Thus, they also h a review of banks' capital plans and on market discipline to assess bank capital ad we go forward, banking supervisors are building a capital framework on these three capital supervision, capital regulation and market discipline - and we look to stren of them.Let me start with capital supervision.

The cornerstone of supervisory review is t process for assessing its overall capital adequacy in relation to its risk profile for capital level and structure.

Supervisors believe they should review and evalu internal capital adequacy assessments and strategies, in addition to bank complia regulatory capital ratios.

The better the bank's own capital adequacy assessment, the supervisor will understand the bank's capital strategy.

Inevitably, this aspect take importance.

For one reason, supervisors expect banks to operate above minimum regu capital ratios included in the Basle Accord - and prudent assessments can help to how much.

For another, supervisors seek to intervene early enough to prevent capit falling below prudent levels - and bank assessments can provide another useful identifying key issues before they become major problems.

With these thoughts in supervisors are tackling the challenge of developing a more systematic approach to t of capital adequacy.Supervisors also are discussing ways to enhance market-based discipline.

Most agre should be a greater role for private-sector monitoring of banks.

Of course, there al a fair amount of market-based monitoring; however, the collection and use of these information usually are not systematic or complete.

The first goal is to improve i available to the market.

With enhanced risk disclosure, supervisors will be more ab on the opinion of market investors.

These opinions are reflected quickly in the pri debt and share prices, and the ease with which banks can access capital.

By relying these market signals, supervisors will be better able to identify and address wan levels at problem institutions.To the extent banks develop disciplined internal approaches to evaluating capital and capital plans, and enhance disclosures, supervisors will be able to place grea on all three pillars and meet the challenges of a more complex financial marketpl common interest is to keep the Basle standards at a level sufficient to ensure soundness, a minimum above which banks will choose to operate.

To achieve this, we fashion a set of standards that does not greatly distort incentives.Supervisors acknowledge that the current regulations and ratios need to be updated t meaningful, given the full range of risks banks face today.

Supervisors are always c to keep pace with financial innovation and improvements in risk management practice this suggests that we will need a frequent monitoring and maintenance program for the and future Accord.In closing, I would like to summarize the key supervisory objectives that we are min we look to revise the Accord and enhance the overall capital framework.

Our first o of course, is to promote the safety and soundness of the financial system.

Our se enhance competitive equality, while allowing for differences among banks basedifferences in their risk profiles.

These were the original goals of the Accord.

Our th develop standards that are fundamentally applicable to banks of varying levels of comple and sophistication, including those in emerging market nations.In developing this capital framework over the next year, we plan to consult closely wit financial and supervisory community and communicate openly about our progress.

By yearend, we hope to have made great strides in furthering our objectives.

Clearly, beyond 20 sound capital framework will help to ensure that banks are well positioned to face challenges and exciting opportunities that the new millennium has to offer.