Mr. Meyer discusses the Federal Reserve and bank supervision and regulation  (Central Bank Articles and Speeches, 16 Apr 98)
Central bank: fed | Type: speech | Date: 1998-04-16

Mr.

Meyer discusses the Federal Reserve and bank supervision and regulation Remarks by Mr. Laurence H.

Meyer, a member of the Board of Governors of t US Federal Reserve System, presented before the 'Spring 1998 Banking and Finance Lectu Widener University, Chester, Pennsylvania, on 16/4/98.It is a pleasure to continue what is becoming a tradition of Federal Governors speaking at Widener University.When you think of the Federal Reserve, I am pretty sure that, in addit speakers at your university, most of you think of monetary policy, interest rates, i finance, and the Fed's macroeconomic responsibilities in all of these areas.

And, macroeconomics lies at the core of what any central bank does.

However, for a var reasons that I will discuss shortly, the Federal Reserve plays a major role in the sup regulation of banks.

Moreover, I believe that the connections between bank supervis macroeconomic policy are not only little understood, but also quite close.

No econ grow and provide an increasing standard of living for its citizens without also having efficient banking system.

Recent events in Asia are just the most current reminder ofI will begin my remarks today by summarizing, very briefly, why and how ba are regulated in the United States.

Then I will outline the key trends that I see banking and financial sector, and the challenges that these trends pose for bank super the final portion of my remarks, I will suggest some directions that I believe we shou when thinking about how bank supervision should evolve over time.

## Bank Supervision and Regulation in the United StatesWhy do we supervise and regulate banks?

The reasons are very straightforw First and foremost, problems in only a small number of banks can, under the right circu become problems in the entire banking and financial systems, with potentially major ri real economy.

Traditionally, this meant protecting against a panic-driven flight t otherwise known as a contagious series of bank runs, that caused a catastrophic decrea money supply and the collapse of financial intermediation.

Today, largely because of insurance and the Federal Reserve discount window, flights to currency are not a real c the United States.

Rather, the stability of the electronic, large dollar payments s moves trillions of dollars a day and in which banks play a pivotal role, is critica systemic risk.

Other potential pressure points, in all of which banks play a key role liquidity of securities, financial derivatives, and interbank funding markets.Our very success at virtually eliminating the risk of bank runs in the Unit has led to a second major reason for supervising and regulating banks.

Deposit insur discount window, and Federal Reserve payment system guarantees - the very things that eliminated bank runs - create what is called a 'safety net' for banks.

The existence o net gives the government a direct stake in keeping bank risks under control, just a insurance company has a stake in controlling the risks of policyholders.

Because insurance and other parts of the safety net can never be fully and accurately pr necessary for us to monitor and sometimes to act to control bank risks in order to p potential call on taxpayer funds.

An equally important, if unintended, consequence of net is that it creates what economists term 'moral hazard' incentives for some bank excessive risks.

That is, the safety net creates incentives for banks to take larg otherwise, because the safety net, and potentially taxpayers, may absorb most of the logamble fails.

Such incentives are especially strong if the bank is close to failure point, bank stockholders have virtually nothing to lose.

Moral hazard is surely not problem today, when banks are healthy and bank capital ratios are high.

But back in 1980s when over 200 banks were failing each year, moral hazard was a serious concern.All right, you may say, I understand why we supervise and regulate banks. why do both the federal and state governments regulate banks, and why do three f government agencies have bank supervisory responsibilities?

And, I hesitate to even a there are separate federal and state supervisors for thrift institutions and credit u case even the questions confused you, let me step back and outline the structure of supervisory system in the United States.If you want to open a bank in the United States, you must get permission a charter - from a government agency.

There are two ways to do this: state government 'state banks,' and the federal government, through the Office of the Comptroller Currency, charters 'national banks.' Thus, each state has a state bank supervisor.

At level, things get a bit more complicated.

The Comptroller of the Currency supervises banks.

But since the FDIC insures certain deposits of both state and national banks, also has supervisory authority over the state and national banks that it insures. national banks must be, and state banks may be, members of the Federal Reserve Syste addition, most banks are organized in bank holding companies, and the Federal Reserve exclusive supervisor of bank holding companies.

Savings and loans and credit unio separate charters, and each has its own state or federal supervisor.In reality, the supervisory system is not quite as complex as it sounds, believe it or not, both statutes and agreements among supervisors divide up supervisory so that regulatory overlap is, to a significant degree, minimized.

This division of l the allocation of primary federal regulator to the Federal Reserve for state member ba OCC for national banks, and to the FDIC for insured state non-member banks.

In additi coordination among the federal regulators in the interest of consistent treatment o facilitated by the Federal Financial Institutions Examination Council (FFEIC).

Still, division of labor and the coordination through the FFEIC, the U.S.

system is rather coWhy do we have such a 'Balkanized' structure of bank chartering and supervi and regulation?

In large part, it is not so much by design as it is the result of re individual problems.

But I believe that there is at least one systematic factor - the desire of many Americans for a decentralized banking system.

An important theme in Ame political philosophy has been distrust of concentrations of power, especially concent financial power.

Thus, from the start of our republic individual states insisted on charter their own banks, and were suspicious of the federal government's efforts to do not until the trauma of the Civil War that Congress passed a National Bank Act that al extensive federal chartering and supervision of banks.Even after passage of the National Bank Act, virtually all banks were se restricted in their ability to operate across state lines.

Indeed, until passage of th in 1927 national banks could only have one office.

While this restriction was relaxe national banks and state banks that were members of the Fed were prohibited from bra outside of their home state.

Restrictions on interstate banking were viewed as imp maintaining a 'dual' banking system in which both federal and state governments could banks, and in which no one bank, or group of banks, could gain too much power.

Restric interstate banking only began to be dismantled within the last two decades, and were pr˝entirely gone by the end of 1997.

However, concerns about preserving a viable dual system are still very much alive.Today, bank supervision and regulation focus on three primary areas of p policy concern.

Safety and soundness supervision attempts to ensure that banks are prudently and in ways that maintain the stability of the banking system.

Enforcemen antitrust laws in banking seeks to foster open and competitive markets that provide hi banking services at minimum prices.

Consumer protection laws and the Communi Reinvestment Act are aimed at making sure consumers are fully informed about the most c characteristics of banking products and services, and that banks meet the financial ser of their local communities, with particular attention to the needs of low and modera neighborhoods.

Congress has required the Federal Reserve to play an active role in al areas.The fact that the Federal Reserve has responsibilities in all of these sometimes strongly questioned.

There has been more than one proposal over the ye remove the Fed from bank supervision and regulation.

I must confess that sometimes whe involved in a complicated supervision issue, I am tempted to feel that someone else sho But in my saner and more reflective moments, I remain convinced that removing the Fed bank supervision and regulation would be a serious mistake.

Let me try to explain why.The central bank, in my experience, needs direct, hands-on involvement i supervision and regulation of a broad cross-section of banks in order to carry out the responsibilities of conducting monetary policy, ensuring the stability of the financ acting as the lender of last resort, protecting the payments system, and managing a crisis.

Meeting all of these responsibilities is not just an academic exercise, it re knowledge of financial institutions and markets, knowledge that comes with being involved in supervising individual banking organizations.

Without such involvemen Federal Reserve would be much less able to maintain both its practical knowledge of and other financial markets, and the influence and authority necessary for macroeconomi and crisis management.

Ivory towers are great for universities, but they are not de central banks.While our supervisory responsibilities make us a better macroeconom policymaker, I believe that our macroeconomic policy responsibilities make us a bett supervisor.

In the course of designing and implementing our supervisory policies, weigh safety and soundness concerns against the potentially adverse effects on the ec excessively rigid regulations.

As Chairman Greenspan has observed, the optimal rate failure is not zero.

Banks must be allowed to perform their economic functions of m accepting, and managing risk.

Taking and managing risk mean that sometimes risk wil costs, including failure.

In my judgement, the central bank is in a unique position t complex and sometimes conflicting objectives of financial stability and a growing e The Fed is less likely to engage in an unnecessarily restrictive or, for that matter loose, supervisory policy than is an agency focused either solely on bank safety and so solely on growth.

Finally, the U.S. central bank, because of its extensive and wellrelationships with foreign central banks is ideally positioned to engage in coordinate managing international financial crises and in supervising institutions that have a international presence.

The on-going crisis in Asian financial markets is our mo example of the need for such coordination of supervision.˝The Federal Reserve is the primary bank regulator of only 5 of the l 25 banks, the large, complex and internationally active banks that are the major s systemic risk.

The Federal Reserve is able, nevertheless, to maintain a flow of inform the risk profiles and risk management practices of all large banking organizations t responsibilities as exclusive supervisor of all bank holding companies.

It is for thi the Federal Reserve places such a great emphasis on maintaining its role as superviso holding companies.

## Key Trends Challenging Bank SupervisorsLet

me turn now to a discussion of the key trends in banking and fina markets that are challenging bank supervisors.

Surely the most profound force that transforming the financial, and other sectors of our economy, is the rapid growth of and telecommunications technology.

In finance, a critical and complementary force has development of intellectual 'technologies' that enable financial engineers to separate various components, and price each component in an economically rational way.

Indeed, Prizes have been awarded for some of these discoveries.Implementation of financial engineering strategies typically requires m amounts of cheap data processing; and the cheap data processing would not be useful wit formulas required to compute prices.

The combination of the two has led to a virtual in the number and types of financial instruments.

Key examples include virtually all financial derivatives, such as interest rate and currency swaps and, more recent derivatives.

Asset-backed securities, from mortgage-backed securities to credit card to collateralized loan obligations, provide additional examples of what can result mixing of technological and intellectual innovation.

Such products have lowered the broadened the scope of financial services, making it possible for borrowers and le transact directly with each other, for a wide range of financial products to be tailo specific purposes, and for financial risk to be managed in ever more sophisticated waysFinancial innovation has been the driving force behind a second major tre banking - the blurring of distinctions among what were, traditionally, very distinc financial firms.

One of the first such innovations, with which we are all now very fa money market mutual funds.

Money market mutual funds took off in the late 1970s as m interest rates rose above rates that banks were allowed to pay on deposits.

Eventuall system of interest rate controls, known as Federal Reserve Regulation Q, was disman market realities and then, as a result, by the law.

In the 1980s, banks began to chall the Glass-Steagall Act prohibited combinations of commercial and investment banking. both the regulators and the courts agree that Glass-Steagall does not imply a total and bank supervisors have allowed a substantial blending of commercial and investment b in the form of so-called Section 20 subsidiaries of bank holding companies.

More r traditional separations of banking and insurance sales have also begun to fall, with s the supervisors and the courts.A major result of the continued blurring of distinctions among commer banking, investment banking, and insurance is a tremendous increase in competition in for many financial services.

Greatly intensified competition has also led to increasi for revisions to many of the banking laws and regulations, such as the Glass-Steagall despite some successful efforts at relaxing them, continue to exert outdated and costl on the banking and financial system.

However, the issues involved are often complex an˝political, and so far efforts to achieve 'financial modernization' have been more piec I would desire.Nevertheless, deregulation has been a major force for change in the bankin financial services industries.

Two decades ago we still had Regulation Q, the Glass-St was widely viewed as requiring a virtual prohibition of combinations of commercia investment banking, and interstate banking and branching were barely fantasies even at level, let alone applications for combinations of insurance and banking.

Just a few da House of Representatives almost voted on a massive re-write of the laws on permissib holding company activities and is now scheduled to consider the issue early next mont difficult to predict the outcome of that bill, and I will not.

But I will note that market developments for changes in the rules set up during the Great Depression are i If Congress does not act, loopholes and regulatory changes will continue to be exploi or without bank participation.

The forces of technology and globalization will deregul way or another.

I and my colleagues would prefer that the Congress would guide those in the public interest, but legislative deadlock will not do the job because the statu hold.The fourth major force transforming the banking landscape is the globalizat banking and financial markets.

Indeed, globalization has been reshaping not only the but also the real economy for at least the last three decades.

The interactions of dev both the financial and real economies have expanded cross-border asset holdings, trad credit flows.

In response, financial intermediaries, including banks and securities increased their cross-border operations.

Once again, a critical result of this rapid been a substantial increase in competition both at home and abroad.

Today, for example 40 percent of the U.S.

domestic commercial and industrial bank loan market is accounte foreign-owned banks.The final significant trend I will highlight is the on-going consolidati U.S.

banking industry.

I think that it is fair to say that the American banking syste in the midst of the most significant consolidation in its history.

As I mentioned earl two decades nearly all of the traditional barriers to geographic expansion of U.S. crumbled.

While the states took the lead in eliminating these barriers beginning i 1970s, the final step was taken by the federal government with passage of the Riegle-Ne 1994.

Under this Act, virtually full interstate branch banking became possible in JuneA few facts will perhaps give you a feel for the profound changes occurring structure of the U.S.

banking system.

In 1980 there were about 14,400 banks in organized into about 12,300 banking organizations.

By the end of 1997, the number o had fallen to just under 9,100, and the number of banking organizations to not quite 7 42 percent decline in the number of banking organizations was due in part, but only i the large number of bank failures in the late 1980s and early 1990s.

A more importa was mergers among healthy banks.

Since the early 1980s, it has not been unusual to se more mergers among healthy banks each year.While mergers have occurred, and continue to occur, among banks of all siz would emphasize three aspects of the current bank merger movement.

First is the high i of 'mega mergers,' or mergers among very large banking organizations.

Several mergers last few years have been either the largest at the time, or among the largest bank merg history.

Examples include the combining of Chase Manhattan and Chemical Bank, Wells F and First Interstate, NationsBank and Barnett, and, most recently, First Union and Co˝Second, despite all of the merger activity, a large number of medium to small banks r the United States.

Moreover, by most measures of performance these small banks are mor a match for their larger brethren for many bank products and services.

Indeed, when merger is announced it is not uncommon to read in the press how small banks in the a markets are licking their chops at the business opportunities created thereby.

Resear support their optimism.

Lastly, while the overall number of banking organizations h since 1980, this does not mean that new, or de novo, entry has not occurred.

From 1980 1997 some 3,600 new banks were formed in the United States.

My bottom line? U.S. banking structure is highly dynamic, is adjusting to a variety of forces, and generalizations.The current wave of bank mergers has led to a substantial increase in concentration at the national level.

For example, the percentage of banking assets co the top 10 banking organizations rose from about 22 percent in 1980 to 34 percent in 1 percentage held by the top 25 increased from 33 to 53 percent.Are these increases in national concentration a public policy concern? view, the answer to this question is 'no,' at least at this time, because virtually al we have strongly suggests that competition problems almost always arise in banking at level.

That is, to the extent that banks are able to exert market power, the exercise tends to occur in retail markets that are relatively narrow in geographic scope, and well-defined set of customers, usually households and small businesses.However, a special influence on local market competition may develop as b consolidation and interstate branching continue, resulting in the largest banks compe each other in an increasing number of local markets.

Such widespread competitive conta cause these firms to temper their competitive behavior in individual markets in recogni potential for responses by their rivals in other common markets and in recognition widespread mutual interests.So, what has happened to banking concentration in local markets since 1 The answer is, 'not much'.

For example, the average three-bank deposit concentration Metropolitan Statistical Areas, a common measure of local urban markets, hovered be 65 and 68 percent between 1980 and 1997.

Concentration measures for rural counties similar results, with the average three-bank concentration ratio remaining at about throughout the period.

Other measures of local market concentration show similar re both urban and rural areas.The stability of local market concentration in the face of such a consolidation of the banking industry is remarkable.

While there is no single reaso stability, I would point to two factors as being of particular importance.

Many including some mergers of very large banks, involve institutions that do not compete in local markets.

In such cases, local market concentration is obviously not affected. merging banks do compete in the same local markets, enforcement of the antitrust laws h an important factor limiting the growth of local market concentration.

Moreover, enforcement has no doubt deterred some highly anti-competitive mergers from even b proposed.Why have banks been consolidating in number and expanding in size an geography?

Again, no one answer is appropriate, and each merger is somewhat unique reflects more than one factor.

In recent years many banks have been responding to the˝of barriers to interstate banking and branching that restricted entry and divided marke cases, the twin desires to diversify risk geographically and to expand sources of 'cor have surely been important motivating forces.

Moreover, geographic barriers had cons natural market developments; in an important sense their removal has simply allowed the to adjust to a new economic equilibrium from a previously legally mandated equilibrium.Beyond such adjustments, scale economies are mentioned frequently by banke as a causal factor in bank consolidation, although academic research has not tended to evidence of overall economies of scale in banking.

Still, economies of scale certainl some bank operations, such as many back office functions.

In addition, some lines of such as securities underwriting and market making, require large levels of activity to Increased competitive pressures caused by rapid technological change and the resulting of distinctions between banks and other types of financial firms, lower barriers to e deregulation, and increased globalization are also important factors.

For example competition forces inefficient banks to become more efficient, accept lower profits, shop, or - in order to exit a market in which they cannot survive - merge with anot Other possible motives for mergers include the simple desire to achieve market power, o by management to build empires and enhance compensation.

Some mergers probably occur an effort to prevent the acquiring bank from itself being acquired, or, alternatively, bank's attractiveness to other buyers.No matter why banks are merging, the bottom line is that the United States on its way to developing a truly national banking structure for the first time in its are not quite there yet, but I do not think it will take too many more years.

Wha structure look like?

Well, that is obviously a very complex question, the answer involves forecasting years in advance.

And I can tell you from many years of exp forecasting the economy even one year in advance is a very risky and humbling business. any prognostications about future banking structure should be taken with very many gr salt.Still, some economists at the Fed have tried to look through this dark gla the future United States banking structure.

For all of the reasons I have discusse reasonable to expect a continued high level of merger activity for the foreseeable fu large mergers will not be uncommon.

Studies based on historical experience suggest around a decade there will likely be about 3,000 to 4,000 banking organizations, do about 7,000 today.

Although the top 10 or so banking organizations will almost c account for a larger share of U.S. banking assets than they do today, the overall size of banks will probably remain about the same.

That is, there will likely be a few organizations, and an increasing number of firms as we move down the size scale.

Impo a large number of small banks is expected to remain.

## Future Directions in Bank SupervisionWhat do all of these changes mean for how we supervise and regulate banks?

## Analysis of competitionClearly,

as the banking industry consolidates we need to maintain compet markets.

Competitive markets are our best assurance that consumers receive the highes products at the lowest possible prices.

As I discussed earlier, there are many reason that in recent years competition has increased greatly in markets for a large number o˝products and services.

This is true for many products purchased in local, regional a markets.

However, in some cases we still observe potential competitive problems proposed bank merger.

Fortunately, the antitrust laws, as written into the banking st us the means to maintain competition in such situations.

These laws require that t approve only those mergers that are not expected to substantially harm competition. implementing this policy, the Board may require changes to a merger proposal, and may deny an application, if the merger or acquisition would result in a highly concentrated an excessively large increase in concentration.

As I indicated a few minutes ago, th our analysis is normally on local retail markets for banking products and services.Over the past year or so, quite a few applicants have pushed very hard Board's frontier for approving merger applications.

Some applicants appear to have view that almost any merger could be approved, even if it violated the screening guide both the Federal Reserve and the Department of Justice use to decide which mergers close examination.In response, the Board has occasionally felt compelled to remind appli especially those proposing a merger that would affect a large number of local marke substantial changes in market concentrations will receive careful review.

Moreove mergers would exceed the screening guidelines, 'mitigating' factors must be presen mitigating factors I mean conditions that tend to create a more competitive market suggested by market concentration alone.

These would include characteristics that market highly attractive for new entry, or situations where nonbank providers of services are unusually strong.

The greater the deviation from the screening guidelines powerful and convincing the mitigating factors must be.I have been particularly concerned with cases where a large number of markets are affected.

In such cases, even if the adverse effect is fairly small in e local markets, it seems to me that the cumulative, or total, adverse effect might be Thus, when a large number of markets are affected adversely, I believe that we sh especially careful to assure ourselves that there are substantial mitigating factors.In addition, when a merger would cause a large change in concentration market that is, or becomes, highly concentrated, I think we need to give special atten impact on competition.

The reason for this is that I think when the change in concen large, the effect on interfirm relationships, market dynamics and thus competition is more pronounced, other things equal.

## Assessing safety and soundnessTechnological

change, financial innovation, the acquisition of new power banking organizations, the increasing geographic scope of banks, and the globaliza financial markets all challenge our ability to examine and assess the safety and sou individual banking firms.

One way that examiners are adapting to this changed world is much of their attention on the information and risk management systems of banks.

T question they ask is:

How effectively are these systems measuring and controll institution's rapidly changing risk profile?

The emphasis on risk management is most our largest, most sophisticated, and most internationally active banks.

Many of these advanced economic and statistical models to evaluate their market and credit risks models are used for a variety of purposes, including allocating capital on a risk ad and pricing loans and credit guarantees.˝The development by some banks of increasingly accurate models for measurin managing, and pricing risk has called into question the continuing usefulness of o foundations of bank supervision - the so-called risk-based capital standards, or the Ba The Basle Accord capital standards were adopted in 1988 by most of the world's industr nations in an effort to encourage stronger capital at riskier banks, to include offexposures in the assessment of capital adequacy, and to establish more consistent standards across nations.

The Accord was a major advance in 1988, and has proved to useful since then.

But in recent years calls for reform have begun to grow.

I will o one of the key problems we are currently facing with the Basle Accord.The Basle Accord capital standards divide bank on- and off-balance sheet a into four risk buckets, and then apply a different capital weight to each bucket.

Th increase roughly with the riskiness of the assets in a given bucket.

The basic idea capital should be required to be held against riskier assets.

However, the relations Perhaps most troublesome, the same risk weight is applied to all loans.

Thus, for e loan to a very risky 'junk bond' company gets the same weight as a loan to a 'triple firm.While the Accord has the virtue of being relatively easy to administer and e it also clearly gives banks an incentive to find ways to avoid the regulatory capital loans that their internal models say need less capital than is required by the Bas Conversely, banks should want to keep loans which their models say require more capit does the Basle standard.

And, guess what, banks have been doing just that.

This 'regulatory arbitrage' may not be all bad, but it surely causes some serious problem For one thing, it makes reported capital ratios - a key measure of bank soundness supervisors and investors - less meaningful for government supervisors and private Finding ways around this problem is a high priority at the Federal Reserve.The arbitraging of regulatory capital requirements is but one of a host of conflicts between banks and bank supervisory rules and regulations.

Indeed, one can vi of the long history of bank supervision and regulation as something of a battle supervisors who want to deter excessive risk taking and banks who seek ways around some inefficient, or just plain uneconomic, regulations.

This long history leads me to seek strategies that are, in the economist's jargon, incentive compatible.

By incentive c mean supervisory policies and procedures that give banks strong internal incentives t their risks prudently and minimize the exploitation of moral hazard.

Put differently, design strategies that encourage banks, in their own self-interest, to work with us, noOne promising possibility for incentive compatible regulation is what has c be called the 'pre-commitment' approach to bank capital standards.

The basic idea is the bank to pre-commit to the supervisor its capital allocation for risks in the ba account - those assets held as part of the bank's securities dealing activities.

If th for that portion of its total risk exceed the pre-committed amount of capital over some period, the bank would pay a penalty, or perhaps have to disclose to the market its vio pre-commitment.

Such an approach would utilize the bank's own internal models and management procedures to achieve supervisory goals, and give the bank a strong incen improve its risk management, since by doing so it could lower its pre-committed requirement and not increase the risk of paying a penalty.˝There are both benefits and difficulties with the approach that we are di with other supervisors both in the U.S.

and abroad.

It may well be that some for incentive compatible strategy might be linked with a regulatory minimum capital modification to the Basle standard for market risk.

Such a modification would be to th standard that, it is important to emphasize, already uses a bank's internal risk m models to help achieve supervisory goals.

U.S. bank supervisors began last year to req internationally active American banks to meet the Basle Accord's capital requireme market risk in trading accounts using their own internal models, with appropriate re monitoring by supervisors.As I suggested at the beginning of my remarks, the possibility of a sy failure of the banking system, and the moral hazard incentives created by the safety designed to contain systemic risk, require some government supervision of banks. should always remember that the first line of defense against excessive risk-taking b the market itself.

Market discipline can be, and often is, highly effective at deterr risk.

Indeed, a primary goal of many of the bank regulatory reforms implemented in the the banking and thrift crises of the 1980s and early 1990s was either to increas discipline or to make supervisors behave more like the market would behave.

Market di was increased by raising capital standards, thus giving the owners of the firm a great to control risk, and by mandating greater public disclosure by a bank of its financia Prompt closure rules that required supervisors to impose increasingly severe penalties as its financial condition deteriorated, and the adoption of risk-based deposit insuran are examples of encouraging supervisors to act like the market.The reforms of the early 1990s were a good start.

But I believe that th well be more that we can do here.

Such comments may sound out of place today.

Time good, and almost everyone seems quite satisfied with the current deposit insurance sys good times may be precisely when we should develop ideas for an even more effective s The crucible of a crisis is not always the best time to think up reforms - witness t made in passing the Glass-Steagall Act, an error we have yet to correct after 65 years! is in part for this very reason that the Board continues to urge Congress to pas modernization legislation.

So, in the spirit of being forward looking, let me attempt the flavor of what I am thinking about.It may, for example, be possible to increase market discipline by requirin internationally active banks to issue a minimum amount of certain types of uni subordinated debt to the public.

Holders of such debt would have a strong incentive the bank to manage its risk prudently.

In addition, it would be highly desirable if t traded on the open market, thereby providing a clear signal of the market's evaluati bank's financial condition.

Another possibility is further reforms of the deposit system.

For example, most observers believe that the current risk-based premiums adequately reflect risk differences between banks, in part because current law limits of deposit insurance reserves.

Loosening this constraint might allow for more accura of deposit insurance.

## Dealing with globalizationThe

final area I will highlight today is a potentially critical impli financial globalization for the supervision of large, internationally active banking o In this world of financial globalization, complexity, and rapid telecommunication extremely important that all of the large banking institutions in the developed natio˝keep up with the state-of-art in risk measurement and management.

If a group of im institutions in only one or two countries fails to keep pace, all banking systems ar increased risk.

This risk, moreover, is not simply that a large bank failure in one cause counter-party failures in other nations.

Systematic underestimation of credit risks can result in underpricing those risks, which can be damaging to all players, not banks making the risk measurement errors.Fortunately, the free market dissemination of best practices appears functioning fairly well.

No single developed nation has a monopoly on best pract measurement and management, if innovations in complex financial products are any indic For example, European banks were market leaders in introducing collateralized loan obli In the field of asset-backed commercial paper facilities, U.S.

banks were the init European and Japanese institutions are now significant players.

And, the ubiquitous c firms around the world can be relied upon to spread the word on advances in risk mana techniques.Still, individual banks in each country, not just the U.S., must face th incentives to keep up with an ever changing technology.

Lax supervisory practices - o government support of banks with poor risk practices - do not provide proper incentive each supervisory authority in each developed nation must be vigilant that the dispariti the world's best practice institutions and those large banks inside the best practice not grow wider.

Indeed, I believe that an important function of supervisors is something of a clearinghouse for best practices.

Internationally, supervisors from industrialized nations have been performing this function more and more through the efforts.

In the United States, the clearinghouse function is an important component of examination.

## ConclusionIn conclusion, I hope that my remarks have helped you to better understan forces affecting our banking and financial system.

Equally important, I hope that I you a good feel for the challenges these forces have created for bank supervision, ho meeting these challenges today, how we may deal with them in the future, and the rol Federal Reserve in these complex, dynamic, and exciting issues.

All of us have a very in the continued health, stability, and competitiveness of our banking system.

I enco of you to think deeply about what is required to achieve these goals.˝˝