Mr. Ferguson remarks on themes in international bank supervision  (Central Bank Articles and Speeches, 20 Jul 98)
Central bank: fed | Type: speech | Date: 1998-07-20

Mr. Ferguson remarks on themes in international bank supervision Remarks by Mr. Roger W.

Ferguson, Jr., a member of the Board of the Governors of the US Federal Re System, before the International Banking Conference, Federal Financial Institutions Exam Council, in Arlington, Virginia on 20/7/98.

## Themes in International Bank SupervisionThe scope of my introductory remarks for your conference today is broad and tou on a number of topics, some of which will be more fully developed by other speakers late seminar.

## Risks and Benefits of a Global Banking SystemLet me start by addressing the question of what value and what risks might ari having a more global banking system such as the one developing currently.

Academic and po literature is full of articles arguing both sides of the case.

Conceptually, global banki mean both direct entry and cross-border inter-bank lending, may influence macro-stability positive and harmful ways.

Those who see potential harm argue that trans-national banks s capital flight, particularly in developing markets, and in stressful times may be a sour outflows and currency crises.

Second, some analysts argue that foreign banks may lack comm to their host country and will flee, or withdraw credit, when faced with problems in local in their home market.

A third concern is that the participation of foreign banks may be with broader efforts at deregulation and may overwhelm domestic banking supervisors, cre riskier environment.Those on the other side of the debate argue that participation in global ban source of stability and improved banking practice.

Proponents of this view claim that for may directly bring new and better basic banking skills, more sophisticated management tech and products better suited to managing and spreading risk.

Through the benefits of com these commentators argue, local banking skills and services will be improved.

In additi observers see indirect benefits from the participation of foreign banks.

They argue that g as either direct entrants or as inter-bank lenders, may accelerate the development of institutions, such as rating agencies, accounting and auditing firms, and credit bure acquire and process information.

Similarly, banks that participate in many national mar improve information disclosure about the banks themselves as the foreign banks compete t market share by demonstrating their comparatively sound financial condition.

Finall proponents of this view argue that participation by cross-border banks may stimulate impro in the supervisory and regulatory framework.I believe that those who argue for the benefits of having a country open to banking may have the better of the argument.

We know, however, that whether foreign banks source of stability or fragility depends very much on the market, banking and sup environments that they find in the host country.

There are conditions that must accompany, still, precede a country's decision to participate in today's global banking market.

If the of foreign banking competitors, either directly or through inter-bank lending, com improvements in the underlying bank credit underwriting culture, the capability of bank su and the degree of transparency, then the benefits of foreign bank participation will emerge.

On the other hand, if foreign banks participate in a country in which neither t transparency, nor domestic banks, nor bank supervisors are prepared to change, I believe participation of foreign banks, by itself, will not necessarily be beneficial and couldnegative.

Therefore, entry of foreign banks, either directly or as participants in the inte market, without movement to better information, better supervision and better banking, access to credit, but not necessarily an increase in macro-stability.

To argue the benef banking in the abstract, removed from these required conditions, therefore seems to miss focus.

## Lessons from the Asian CrisesLet me now turn to the broad-based lessons that the Asian crisis teaches us. the most important contributing factors to the current financial crisis in many of the eme nations was the weakness of their banking systems, as well as weakness of bank supervisio those

countries.

It seems clear now that, Asian banks, as well as their government su violated some of the fundamental principles of banking and banking supervision.

Banks' ma had not developed adequate processes for underwriting loans and monitoring their con performance, or of establishing sufficient and timely reserves to buffer expected loan loss these problems stemmed from lending directed by governments, which led to expectations th government would support such loans, if needed.

But, the primary cause of these credit p stemmed from banks' failure to deploy effective tools of credit risk analysis.The absence of credit risk analysis led to financial structures that were i fragile.

Banking supervisors in these countries proved ill-equipped to compensate for the Poor allocation of credit undermined the prospects for sustained economic growth.

Some bor could not service their loans.

As these domestic banks' loan portfolios deteriorated financial condition eroded, their creditors, domestic and foreign, looked at them more cri began to withdraw their funding.

In short, the deteriorating condition of borrowers hurt t system, which increased economic harm to the rest of these countries' economies.Two other features of these countries' financial systems have compounded problems caused by poor lending practices and inadequate supervision.

First, standards transparency and disclosure of private financial information were extremely lax.

It was d creditors, foreign or domestic, to distinguish good risks from bad, and this caused them t and, later, withdraw credit from borrowers within these countries without full knowl borrowers' creditworthiness.

This latter reaction exacerbated the crisis for the busi citizens of these countries.

Second, creditors to banks no doubt relied to some extent safety net to back up their claims.

This was true not only of small depositors, but als bank creditors.

As it turned out, the presumption of public support was at least to s misplaced.Therefore, participation in the global banking market did not work to save countries from fundamental information, banking and supervisory weakness.

The fact th information, credit and supervisory cultures had not yet changed, even with the partic foreign banks and the extension of inter-bank credit, meant that ultimately these financ were proved fundamentally flawed.We have also learned, or relearned, other lessons because of the handling o crises.

First, prolonged delay in tackling systemic banking sector weakness invites furthe not strengthening.

Delay in the hopes that the economy will grow banks out of their pro attractive, but is actually a trap.

Because of the credit allocation role that banks economies, delay allows problems to grow.

Inefficient banks are allowed to allocate inefficiently, and open, insolvent banks, in effect distribute taxpayer money to bank sh employees and borrowers.

Second, extra attention is required to solve systemic bank wea because of the inherent pitfalls associated with banks that are 'too-big-to-fail'.

Becauseclosing very large banks may not be credible, it may be more difficult for supervisors t very large banks to improve their operations.

As a consequence, supervisors need to have c authority, and political support, to order banks to take a variety of steps to improve the This is a lesson that we in the United States learned only recently, and supervisors he required to order banks to take remedial actions as capital falls below 8 percent.

## Reactions of the International Supervisory CommunityThe

international supervisory community has heeded these lessons and reacte them.

International recognition of the need for strong, effectively-supervised banking sys reason that the Basle Supervisors Committee issued its 1997 paper, 'Core Principles of Banking Supervision.' Bill Rutledge, Senior Vice President of the Federal Reserve Bank o York, will discuss this paper with you after your break this morning.

I cannot over importance of adopting such core principles of sound banking and banking supervision international banking system, and also the need to develop a workable mechanism for enforc implementation of these standards.The Asian crisis also underscores the importance of transparency.

Adequate ma discipline depends on investors having information that is sufficient in quantity, rel timeliness.

In recognition of this, the Basle Committee is now exploring the possibility benchmarks for providing information about financial institutions that should be availab supervisors and markets.

International progress toward greater transparency is a vital i the markets and sound supervision.

More broadly, I believe that the time is appropriate to wide-spread adoption of international accounting and disclosure principles that raise the accounting treatments in all countries.

These standards should focus on three goals. international accounting principles should provide the basis for depicting a clear and fa the condition of the bank and of corporate creditors.

Second, any principles should provid by which firms identify and disclose their major risks, such as funding, foreign exc concentrations.

Finally, compliance with these principles should be sufficient to suppo confidence in the basic integrity of a firm's published financial statements and other discBecause of the increasing complexity of financial instruments and the spe movement in financial markets, intrusive supervision has become less meaningful, if not impossible.

Thus the federal banking agencies have adopted a risk-focused approach to b supervision that emphasizes the adequacy of banks' internal risk management systems.

Events financial markets today occur too quickly to give anyone a comfortable learning curve in with financial problems.

I believe that our objective should be to make managers and in behave as if there were no safety net and align their natural market-driven decisions with objectives.

Together with the traditional approaches of loan review and transaction mo market-based supervision will best ensure the continued viability of the banking sector. and are, actively searching for other methods to create incentive-compatible regula supervision.The Asian situation highlights the value of a reliable system for US ba supervisors to assess banks' country risk, which I know has occupied some of you recently. of you are aware, the federal banking agencies, through the Interagency Country Risk E Review Committee (ICERC), are developing an improved guide for examiners in evaluating country-risk exposure in banks.

This system will permit examiners to be more thoroughly i on countries in which US banks have exposure and allow for a better cross check against country risk management systems.

New risk-focused examination procedures will also b by-product of the current review of management practices.Finally, the Asian crisis and the speed with which it occurred demonstrate t for effective international communication and coordination.

You confront this need in yo work in supervising global financial conglomerates.

These large diversified companies, w becoming more prevalent in domestic and global markets, blend banking, securities, and financial activities in a single diversified company operating across national borders an industry lines.

This presents a significant supervisory and examination challenge because m legal systems of the countries in which these firms operate are structured along national geographic regions.

Many of these countries, including the United States, continue to different supervisory approaches, implemented by different regulators, for each traditiona the financial services industry.

The crossing of national and industry lines can result financial services supervisors having responsibility for theoretically distinct pieces of conglomerates, but no supervisor having clear authority to coordinate supervision of t jigsaw puzzle of each conglomerate.

This is a critical deficiency because these conglome working to coordinate and integrate their business operations and supporting systems to th extent feasible.This is why the Joint Forum on Financial Conglomerates in February issued consultative documents, 'Supervision of Financial Conglomerates'.

This international coor group is a joint initiative of the Basle Committee on Banking Supervision, the Inte Organization of Securities Commissions (IOSCO), and the International Association of Ins Supervisors (IAIS).

The Joint Forum's consultative documents make concrete recommendations steps that supervisors in each of the securities, insurance, and banking sectors can take supervision of the group-wide risk exposures of these global and inter-industry conglomera key recommendation is for the international supervisory community to agree on one or coordinators to facilitate international and inter-industry cooperation.

The specifics clarified, but you should all be aware of this international initiative, while also recogni work remains to be done in this country to deal with the complex issues that arise international and inter-industry activities of these firms.

## Domestic Supervision of Foreign Banking OrganizationsMoving now from Asia to domestic issues, the International Banking Act (IBA) perhaps

the most notable of the laws governing the activities of foreign banking orga (FBOs) here in the United States.

The IBA requires, among other things, that, in order to branch application, the Board must determine that a foreign bank is subject to compre supervision or regulation on a consolidated basis by its home country supervisor.

This re as you are undoubtedly aware, is commonly known by the initials CCS.

I believe that the Reserve should continue to be rigorous in applying the CCS standard.

The Board should al great care in allowing entry into the United States by foreign banks from a country where C yet in place.

In these countries, appropriate conditions could be imposed on the operation branch to help compensate for the lack of full CCS.Finally, let me raise an issue that symbolizes our global interdependence: th challenge of being ready to turn the calendar page on December 31, 1999.

As you are all we the Federal Reserve, as well as the other banking agencies, have a keen interest in the readiness of all banks in the United States and overseas.

While all banks must address Y readiness issues within their organizations, the issue appears to pose special problems banks operating branches and agencies in the United States.

To address the Year 2000 prob these banks, and international banking generally, the Federal Reserve is taking an activ number of international initiatives, most notably including the Joint Year 2000 Council, jointly sponsored by the major international bodies for cooperation between financial regulators.

The Joint Year 2000 Council has made a good start at its task.

I am sure tcontinue to raise the visibility of this issue, help all countries recognize the magnitud 2000 challenge, and provide guidance to and assistance for supervisors and financial participants in understanding the steps they need to take to meet the challenge.

I r particular to the Council's current paper on guidance to supervisors, which gives concret assessing preparations by financial institutions.

Going forward I know that the Council provide guidance on developing testing programs and contingency plans.One focus of our concern with protecting the banking system in the United Sta that many US offices of foreign banks may be particularly exposed if their parents are not the Year 2000.

Therefore, we have asked the US branches and agencies to confirm that they able to continue to conduct business using the usual standards for readiness that we domestic banks.

We are also examining foreign banking branches and agencies, as we have domestic banks under our supervisory authority.

The initial round of examination of US b and agencies has been completed, and individual foreign banks are being made aware of the rThere are, of course, a number of competing initiatives that further stretch t information systems resources available to achieve preparedness.

In Europe and other par world, the introduction of the Euro, and the coordination of systems within the Euro-cou requiring extensive planning and programming.

In Japan, the 'Big Bang' will likely ta management focus from Year 2000 systems issues.

Particularly in light of these competing d for system resources internationally, foreign and US banks need to recognize the magnit importance of the Year 2000 conversion effort.

Banks need to take action now to devote su resources to this critical mission.

Senior management of banks and FBOs is responsible fo with Year 2000 issues.

It is not a technical issue alone; it is also a strategic business i

## ConclusionI believe that the emergence of modern international banking is probably likel beneficial.

While international banking holds the potential for macro-stability, the financial crises, including the current ones in Asia, also shows how weakness in banking and banking supervision may contribute to macro-instability.

The prescription to avoid, o minimize the impact of, future crises includes a combination of solid banking skills, well banking oversight at the national level, greater transparency, risk-focused and incentive banking supervision, and coordination among international banking supervisors.While creating this long-term environment, we must also respond to the m immediate challenge of protecting our domestic financial system from poorly supervised entities and from the risks inherent in technology as we go into the new millenium.