Mr McDonough discusses issues of credit risk management and the level playing field  (Central Bank Articles and Speeches, 24 Nov 98)
Central bank: fed | Type: speech | Date: 1998-11-24

## Mr McDonough discusses issues of credit risk management and the level playing fieldSpeech by the President and Chief Executive Officer of the Federal Reserve Bank of New and Chairman of the Basle Committee on Banking Supervision, Mr William J.

McDonough, at conference on 'The Challenge of Credit Risk' in Frankfurt am Main on 24/11/98.I am pleased to be here today to discuss issues of credit risk management and the lev field.

This conference on credit risk provides a focal point for discussion at a ti credit risk management process is undergoing rapid change.

I congratulate President Ti the Deutsche Bundesbank and the Zeitschrift fuer das gesamte Kreditwesen on bringi together for this thought-provoking program.Ensuring a level playing field was one of the two major goals of developing the Basle Accord, the other being to ensure a safe and sound banking system through adequate capi Basle Committee now is engaged in a fundamental review of the Accord, and one impor aspect receiving careful consideration is the changed landscape of the playing field sinThe supervisors' interest in the playing field, to be sure, is not limited to the natur and their competitive positions.

Given the importance of credit and liquidity to t economy, supervisors also have a strong interest in the broader issues of how capital affect the shape and functioning of the financial markets overall.One implication is already clear -- that the capital rules need to have the broade applicability to be effective not just to meet both goals of the Basle Accord, but also soundness and stability of the financial system more generally.

Thus, after describing challenges in designing a 21st century capital framework for an altered playing fie address two broad risk management considerations.

The first is how competition has reshaping the credit cycle in the recent past.

I believe strongly that increased com raised the ante for financial institutions and supervisors alike in their need to deve tools to assess risk and to evaluate the relationship between risk and return.

The se competition is redistributing credit risk in the financial system and how that affects that remains with financial institutions.

Here, too, I believe that competition has rai for all financial institutions, and banks in particular, in their need for a compr consistent credit strategy across all product lines.

Moreover, these changes have impli the supervision of capital adequacy, and not only the design of a regulatory minimum standard, an issue I will return to later.

## Changes in CompetitionThe competitive landscape of the credit markets has shifted dramatically in the decade announcement of the Basle Accord.

Three features in particular stand out.

First, int competition now reaches banks in developed and emerging market countries alike, even i were previously thought to be solely domestic markets.

Second, large banks now compete to-head with nonbank financial institutions, especially securities firms, in a variet markets globally.

Probably nothing has underscored the extent of this head-to-head com more than the entry of investment banks into the syndicated lending business in the m and the subsequent erosion of spreads and nonprice lending terms, while commercial bank entered the high-yield bond underwriting business.Third, the relationship between banks and their highest quality government and b customers has changed, to varying extents in different countries.

Even here in Germcountry virtually holding the patent on the concept of Hausbank, we see change.

Whe Germany or elsewhere, customers have turned to the capital markets to obtain less financing.

The top-rated customers often provide more business to banks in foreign e and over-the-counter derivatives than in traditional lending.

In addition, large nonba capital, such as mutual funds and pension funds, have shown an increasing appetite for investment-grade securities, at least until recently.

These nonbank pools of capital represent one of the most important forces reshaping the playing field, since they si erode the historical comparative advantage of banks in bearing credit risk.International competition and nonbank competition have clear implications for the futur framework if it is to meet the goal of a level playing field.

We must ensure that bank in every country have in place meaningful minimum capital requirements based on a com notion of bank soundness and the power to enforce those requirements.

With respect to m capital requirements, it seems unlikely that one size will fit all.

We can, howeve develop a capital framework in which banks bearing similar risks face similar levels of capital while complying with requirements that are appropriate to the bank's activitie of sophistication.

Analogously, a long-run goal of bank and nonbank supervisors alike s to put their capital regimes on a more nearly common conceptual footing -- not necessa identical requirements, but with a greater degree of comparability.

## Risk, Return and the Credit CycleIncreasing competitive pressures and the changed playing field have contributed to i changes in the dynamics of credit markets.

A concern for supervisors is the tendency markets to bid down spreads rather sharply in the optimistic phase of the credit cycle, point where returns no longer seem commensurate with risk.

Then, as problems emerge, l in the credit markets pull back and cause spreads to reverse sharply.

This is by no me a simple, up and down process.

I recall the bumpy landing of the high-yield bond and l buyout lending markets in the United States at the end of the 1980s.

After several interruptions resulting from failed deals in the late 1980s, the market finally se pronounced downturn which culminated in the failure of Drexel Burnham Lambert in 1990 substantial losses from bridge loans and leveraged buyout credits at many securities banks.Those events from the late 1980s illustrate market dynamics which have been repeated mo once in the last decade -- in Latin American investment and lending in the mid-199 example, and in Asia, Russia, and related markets in the late 1990s.

Credit to highly hedge funds and similar institutions probably falls into this pattern as well.

The com is an initial rapid expansion of credit accompanied by falling spreads, followed by a of activity and a dramatic widening of spreads.

Usually, market participants suffer losses in that second phase.

Often it seems that the longer and more buoyant the optimi of the cycle, the greater the damage when the pessimistic phase sets in.After the early 1990s, when many banks experienced severe credit losses, some set identifying ways to better assess and control credit risks.

That early 1990s experience have sharpened the awareness of banks of the asymmetric and cyclical nature of returns markets.

That is, credit involves a limited upside and a large potential downside, potential depth of the downside becoming convincingly apparent only after the downtu begun.The losses in the early 1990s prompted banks to find new methods to evaluate both the r the returns in credit activities.

These methods included more refined internal rating describe credit quality, analysis of historical loss rates, default probability mod credit risk models and, more recently, stress testing.

As new tools are developed, the combined with others to refine the bank's understanding of its credit risk relative t Because the returns in credit activities are asymmetric and cyclical, new approaches to and analyzing credit risk easily become data-intensive and analytically complex.Can we moderate the sharp turns in the credit cycle?

I believe that targeting commensurate with risk over an appropriately long time horizon is probably the sing important defense against the violent swings in the credit cycle experienced in the 1990s.

Individual banks can protect themselves if they recognize when margins become to to cover risk by restraining their credit activities at those rates, and they can benef them when returns have risen enough to cover risk once again.To limit those market swings, however, the discipline of seeking returns commensurat risks has to be practiced widely and consistently throughout the financial system.

Whi bank may protect itself in the first instance from making loans that allow a bo overextend itself, the borrower may still be able to borrow elsewhere, to the detri current lenders.Risk-return discipline is achievable with even the most basic tools.

Discipline has b enhanced at some large, international banks by the simple comparison of credit sprea historical loss rates on well-defined categories of credit.

A useful approach to fur return analysis is the enhancement of methods to assign internal risk ratings to indiv exposures.

Ratings have long been seen as powerful summary indicators of risk, but a fr of activity appears underway, in which some banks have increased the number of r categories in order to sharpen distinctions within the credit portfolio.

Some bank exploring the possibility of validating their internal ratings through the use of info the equities markets.Finer risk distinctions, when they reflect the likelihood of default, deterioration a banks the possibility of more accurate pricing.

An article in the August 1998 Federa Bulletin provides some evidence of that.

Based on data from some 250 U.S. banks and 29 banking organizations, the authors found that the relationship between internal ra pricing was very similar to the credit rating and pricing relationships that exist market, especially for high-grade customers.Banks which are developing credit models are doing so to deepen their understandin analysis of the relationship between risk and return in credit activities at the portf developers of models believe that, when well thought out, soundly estimated, and des capture the relationships between the risks of individual exposures, credit risk mode risk measures that can reflect portfolio diversification or the lack of it.

Such cred offer the ability to look at the marginal risk and the marginal return of adding a new to an existing credit portfolio, or removing an old one, allowing a credit officer t better whether a loan diversifies the bank's portfolio or increases its concentration.Taken together, these new tools are expanding the capacity to run realistic stress tes fuller picture of credit risk.

Stress testing is the leading technique to assess the di effects of unusual market and economic events.

It is fundamentally a qualitative and j process, usually superimposed on a more formal, statistical approach to risk measuManagement's goal is to identify scenarios, usually low-probability, high-stress ev could jeopardize the health of the bank.

While stress testing has gained prominence turbulent times, running 'what if' scenarios and following up with management actions h been a hallmark of excellent financial management.Although stress testing of market risk exposures has been developing rapidly for seve credit risk stress testing until recently has been a more difficult, manual process.

Th of credit exposures through internal ratings and the use of risk models helps to au process, allowing the bank to analyze a larger number of scenarios in more depth.

Su tests begin at the level of the individual credit or obligor, where able credit officer the ability to identify scenarios most likely to have an adverse effect on the b counterparty.

Stress tests then can be taken to the portfolio level to measure the broa adverse market and economic conditions.

I believe the real key to this kind of analy extensive data-crunching but fully understanding the credit strategies of the bank those strategies may be vulnerable.

## Analyzing Risk and Return as Part of the Supervisory ProcessWhile these new methods of assessing risk and return are to a large extent works in they are likely to have great value well before they are perfected -- if they ever can The use of new methods -- initially as a complement to more traditional approaches -powerful test of their efficacy.

For example, many bankers feel that their market ri were not helpful enough in clearly identifying the risks that generated losses in turbulence of the last 18 months and have begun an assessment of their performance.

As of that review, it is likely that banks will modify their models and the way they use especially by placing more emphasis on and expanding stress testing.

Moreover, man considering ways to integrate the analysis of major risk categories given the links bet risks revealed in the recent market turmoil, such as the link between market and cre associated with the Russian default.As banks use and continue to refine new frameworks for evaluating risk and return, a question for supervisors is what use they should make of the new approaches.

Let me three reasons why we supervisors should devote attention to them in our own superviso contrast to regulatory -- activities, and sooner rather than later.First, by using new methods of relating risk and return, we come to better unders measures themselves, as well as how the bank understands what risks it is taking a Understanding the bank's perception of its performance and comparing it with the supe perspective is a crucial first step to effective supervision and the resolution of probSecond, if we believe that a more rigorous consideration of return relative to risk discipline for banks and the financial system, we need to know whether an appropriately decision-making process is in place and well-functioning.

This requires supervisors to not only asset quality, that is, the risk in the portfolio, but also the bank's prici broader consideration of both risk and return may then suggest new methods to supplem deepen our current, well-established approaches to judging the adequacy of credit loss and capital based on the review of asset quality.Supervisors traditionally have stayed away from forming judgments about the pricing of In part, this stemmed from an appropriate desire to avoid interfering with the basic ma that set prices for individual credits, and we must continue to avoid such interferencasset quality alone cannot answer the question of how well a bank manages its credit ri sheds no light on whether the bank is adequately compensated for its expected losses andThird, new, more incisive measures of risk open up the possibility to increase the com across banks.

One of our greatest advantages as supervisors is our ability to lo institutions and compare them.

The better we can estimate the risk in financial instit these and other measures, the more powerful our comparisons, especially cross-insti comparisons of risk management, earnings, liquidity management, loan loss reserves, course, capital adequacy.

To the extent that banks also disclose robust measures of t market participants will be able to make the same kind of comparisons and exert discipline on financial institutions.

## The Importance of a Comprehensive Credit Risk StrategyA bank's choices about risk and return lie at the heart of developing a credit strategy credit strategy has become more challenging in light of changing competition, not only larger

financial institutions have become more diversified and global, but also be market distributes credit risk far differently than it did a decade ago.

Institutional other nonbank financial institutions hold a larger share of assets and a larger share than they did earlier.

While this is notoriously difficult to measure, given the many the financial system over the last 10 years, a recent study on systemic risk by the Eu Standing Committee under the G-10 Central Bank Governors documents a shift of finan activity away from the traditional banking sector in many countries.While an increasing share of conventional credit risk is being intermediated through t markets, over time larger banks have increased their involvement in intermediating othe market, operational and settlement risks, for example.

Experience is showing us t intermediation of other risks appears always to involve some element of credit risk. explicit credit risk-taking in the form of margin lending, or transactions in the ove derivatives business, which is basically a credit business.

It may take more subtle for the short-term credit risks in futures brokerage, where the clearing broker stands b customer and the exchange, or the often underestimated but substantial credit risks foreign exchange contracts.

Credit risk may derive from operational risks, buried de details of specific operations which make use of intraday funding or other very short-l In its broadest definition, credit risk may take the form of the reputational risk th involvement with the wrong customer in a deposit transaction.Underappreciated and unconventional credit risks have been a theme in major market since the stock market break in 1987.

Such surprises include losses and temporary gri clearance and settlement associated with the stock market break in 1987, the failures and Barings, and the emergence of large credit exposures in non-deliverable fo repurchase agreements and derivatives associated with emerging market currencies government securities over the last year.Credit risk at large banks therefore appears to be becoming less traditional and more nature.

That in turn heightens the urgency of the need for every bank to study and broad credit strategy.

Such a strategy would cover the types of customers, the a relationship between risks and returns, the role of active portfolio management and the diversification that the bank would seek in its businesses.

In the days when the pr credit business in the bank was lending, credit strategy could be largely a matter of area's business plan.

Today, however, the board of directors and senior managementfinancial institution need to know that their strategy covers the many activities of which credit exposure, wherever it is found, is a significant risk.One lesson we can take away from the events of the last 18 months is that the bank' strategy needs to take explicit account of downside scenarios and stress events.

Over t months, as markets were most unsettled, supervisors and central banks became concerne banks and other financial intermediaries would not perform their crucial intermediati see it as important that credit strategy in a bank reflects an analysis of potential vu major customers or groups of customers and consideration of reasonable actions the ban take when distressed circumstances occur.

When difficult times as well as good ti factored into the credit strategy, bank management is in a stronger position to develo for capital and liquidity.Supervisors can pay more attention to the bank's credit strategy, for the same three cited earlier: to promote sound practices, to ensure that those sound practices are in strengthen our basis for comparisons across banks.

Supervisors can explore ways to inc coherence in the review of credit risk management across the bank, especially to ensure management has articulated a comprehensive credit risk strategy and is measuri performance against it.

Supervisors also can verify that seasoned credit judgment a technical analysis is reflected in the credit-granting and monitoring process for tradi Many problems of the last 18 months might have been reduced or avoided by more in-d questioning of the business purpose or strategy of transactions.

## Credit Risk Management and CapitalLet me talk about one last area in which the bank's risk-return discipline within a com credit

strategy matters.

That is the assessment of capital adequacy.

My comments h directed less at minimum capital standards than at the way supervisors form judgments bank's capital adequacy.For virtually all banks, credit remains the single largest risk.

Credit remains a di offset, despite advances in credit hedging techniques, and even diversification has its As banks think through their own capital adequacy, how they factor in their credit risk a major impact on the amount of capital they will need.Capital supports the credit risk-bearing activities of the bank in many ways.

Clearl with reserves, capital should protect the bank against expected and unexpected loss credit portfolio, including losses related to reasonable and plausible stress scenario also protects the bank against its business risk, that is, the risk that a bank wi relative to its competitors or competing products, and fail to earn a market rate of business.

Capital also provides a cushion against the enormous costs of fast-paced tec change, especially in the information systems arena.

For example, consider the urgency rising cost estimates of Year 2000 remediation, testing and contingency planning effortIt follows that every bank needs to assess its risk profile and evaluate what capita cope with adverse outcomes in normal times and under reasonable stress scenarios.

Many have started to do so.

At some banks, the starting point for that analysis is a set of market, credit and perhaps operational risk, with some method for adding them up.

A approach might be to build up capital needs business by business, using peer ana information from the equities markets.

Other approaches are conceivable.Such self-assessments of capital adequacy appear to be an important step toward introdu methods of risk evaluation into the capital process.

As bank management works through assessment, I would encourage participation by its supervisors, so that manageme supervisors have the opportunity to compare perspectives on the nature and amount of th risks, the quality of its risk management, and the adequacy of its capital.I see informed supervisory review of capital adequacy self-assessments as one part of a framework for capital supervision that consists of a minimum capital requirement, h supervision and enhanced market discipline.

The Basle Committee's Steering Group on Future of Capital, chaired by Claes Norgren of the Swedish Financial Supervisory Aut plans to bring its thinking on the Capital Accord to the December meeting of the full C The Committee is committed to undertaking substantial work in 1999 in order to be a publish a consultative paper with its proposals toward the end of 1999, with the beginning the transition to a new capital framework roughly a year later.Of course, some of the many minimum capital standard options being studied by the St Group make use of the new tools of risk-return evaluation I've discussed today, such a ratings and credit models.

My message today is that we can begin now to place more em on risk-return discipline with an appropriately long time horizon and on a comprehensi strategy both in the risk management processes at banks and in our own supervisory p And we should not allow making further progress in the risk management arena to be dep on the outcome of discussions of an appropriate minimum capital standard.As we move forward with the review and revision of the Accord, we plan to s communication with banking supervisors globally and with supervisors in other key fi industries, such as securities and insurance.

We have an especially strong interest in the capital framework we develop meets the needs of banking supervisors outside the countries.

At the meeting of the International Conference of Banking Supervisors in Sy month, regional associations of banking supervisors discussed the obstacles and challe face in implementing the Basle Committee's Core Principles for Effective Banking Superv That discussion underscored the importance of simplicity, clarity and continuity with approaches for supervisors in many parts of the world.A parallel dialogue also is necessary with the broad financial community.

We will ne input and participation to enable us to develop the structure and key elements of framework, understand its efficacy and incentive effects, and evaluate its robust intention is to begin an active dialogue with the industry in the next few months, so their involvement from the beginning.

That dialogue, I hope, can be extended to rating and securities analysts, who play an important role in market discipline.

To conclude Committee on Banking Supervision has taken on a challenging agenda; the work on the f capital framework is likely to involve all of the Committee's working groups and a lar its resources.

We look forward to the challenge in the coming year.

Our hope is to se the complexity of financial activity and the variety of supervisory needs across cou financial institutions in order to identify the most simple, straightforward outlines framework.

If we can identify that framework, we can differentiate it and apply it to b cutting edge of financial engineering or those new to the international markets, to ban small, and to nonbank financial institutions.Ideally, I believe such a framework will include an approach to quantitative capital re that offers the possibility of translating our expectations for all types of financi across countries; integrating the quantitative capital requirements with a set ofexpectations for banks in managing their risk and evaluating their capital needs; and much as possible on market discipline, with emphasis on transparency and disclosure.We will actively seek your suggestions and reactions.