Mr. McDonough discusses the importance of sound financial systems  (Central Bank Articles and Speeches, 22 Jul 98)
Central bank: fed | Type: speech | Date: 1998-07-22

Mr. McDonough discusses the importance of sound financial systems Remarks by the President of the Federal Reserve Bank of New York, Mr.

William J.

McDonough, a presentation in Mexico City, Mexico on 22/7/98.

## IntroductionI am delighted to be here today in my second-favorite country in the world to you on the very timely subject of the importance of sound financial systems.

Having worked with my friends in the public and private sectors here over the years, I know the importan issues to them.

Judging by the attendance here today, this interest appears very broad positive sign for the continued revitalization and strengthening of Mexico's banking sectorMy remarks today, necessarily, reflect my perspective as president of the Reserve Bank of New York, which supervises the majority of domestic and foreign bank ass the United States, and as Chairman of the Basle Committee on Banking Supervision, a pos accepted last month.

These positions allow me a front-row seat on the wide range of devel taking place in international banking and banking supervision, a perspective which I hope with you today.To understand the importance of sound financial systems, one need only look a impact of financial system breakdowns, of which, unfortunately, there are many recent ex Indeed, prior to the onset of the Asian crisis, the IMF had estimated that fully three-q member countries had experienced significant banking sector problems since 1980.

Ban problems have afflicted both industrial and emerging market countries, including the US weathered the savings and loans and banking problems of the 1980s and early 1990s.Crises around the world have exacted a high price, with direct fiscal co associated resolutions typically starting at roughly 5 percent of GDP (in the US case, suc more than $100 billion).

To these substantial sums, one must add the less quantifiable, real, consequences for the economy and financial system.

A weakened financial sector canno its role as intermediary - as banks seek to repair their balance sheets, restrict new lend up capital - leading to diminished growth prospects.

In a number of Asian countries today, have difficulty obtaining trade financing from domestic banks, delaying the process of recovery and raising fears of a credit crunch in which even sound companies are driv bankruptcy.

Banking sector problems reduce depositor confidence in the banking system an trigger capital flight.

Banking system problems, significant in their own right, can caus in monetary policy, render monetary policy tools less effective, and put at risk the int payments system.

In an integrated international financial system, it is increasingly diffic a banking crisis within a country's borders.

Finally, we must not forget the human conseque financial and broader economic crisis, which disproportionately fall on those least able the storm.Clearly we need to learn what we can from recent history and take steps now to domestic and international financial systems more resilient.

Crises are opportuni implementing change, and in the US and internationally, significant reforms traditionally born of crisis.

To effect meaningful and appropriate reform, however, we must fully un cause and effect and the broader trends of international financial intermediation.

Today, to share with you my perspective on these issues based on US and international experien special emphasis on the need for additional preventive measures.

## Importance of sound banking systemsOver the long run, a nation must be able to mobilize domestic savings and sources of funds needed to finance investment and other productive expenditures.

This req development of an effective banking system that transfers surplus funds of househol businesses to borrowers and investors.

Fair and impartial allocation of credit accommod economic development that results in improved national living standards.

Notwithstanding changes in the intermediation process which have reduced the role of banks in favor of t markets, banks retain a critical role in direct intermediation and as managers of financia financial institutions, and banks particularly, remain integral to a sound economy.Effective financial intermediation is particularly important in the context emerging market countries given the relative scarcity of savings, a relatively und population, and large-scale investment needs.

The banking sector in emerging market countr tends to be more concentrated and represents a larger share of the domestic financial suggesting that problems there will have an amplified effect on the economy and on the fi associated with bank rescues.

## Causes of banking system problemsBanking system crises have many and complex causes, both macro and microeconomic.

Macroeconomic causes include exogenous shocks, sustained or sharp decline real growth, accelerating inflation, deterioration in the terms of trade, and changes i regime.

Macroeconomic shocks also typically expose underlying microeconomic deficiencies i management practices and internal controls at financial institutions such as weak und standards, insider lending, excessive credit growth and credit concentrations, interes exchange rate mismatches, and fraud.

They also tend to reveal weaknesses in financial supervision and regulation.

The threats to financial system stability are many and interact ways.

## Policy responsesReflecting the many causes of financial system distress and differences in conditions and institutional settings, responses to financial system crises typically have and hybrid.

Banking sector restructurings are art as well as science, and can be influence of factors, such as the depth and breadth of problems in the banking, corporate and h sectors.

Other critical factors include the existence of adequate enforcement mechanisms t corrective action and of financial markets that are deep enough to permit the orderly d problem bank assets.

Indeed, there is no 'one size fits all' solution, and individual co tailor their approach to their own conditions.

Moreover, crises typically evolve in un ways, and policy must be sufficiently fluid to adjust to changing conditions.

Nonetheless, have taught us important lessons applicable to the current situation worldwide.First, it is imperative that bankers and authorities be realistic about the problems they face.

While it is often difficult to accurately gauge the scale of problems of the crisis, history shows that problems usually are much larger than they first a estimates often are subject to frequent and significant upward revision.

While pressures through may, at times, be almost irresistible, policymakers and bankers must realize that inaction and denial are substantial and that problems left unaddressed grow rapidly over tiSecond, it is important to recognize that financial system distress t encompasses weaknesses in many individual areas, and effective solutions need to be comprehand multidimensional.

Solutions usually involve complex tensions and trade-offs:

improv condition of the banking sector, for example, may have the effect of worsening the condit corporate and household sectors, which may, in turn, negatively affect the banks.

S liquidating problem banking assets may put additional downward pressure on a broader ra asset markets and further exacerbate banking sector problems.

However, asset retention mo than not erodes values and freezes market liquidity.

Policymakers face difficult choices i problem bank restructurings, and there is a great need for creativity in devising solutionsThird, crisis situations cry out for solutions to be adopted quickly to ste deterioration.

At the same time, however, solutions adopted in the short term need to acco long-term consequences for market efficiency, particularly with respect to moral hazard.

T priority at the outset of a crisis is usually to restore confidence in the banking system authorities in a number of countries have implemented guarantees of bank deposits or broa liabilities, in some cases both domestic and foreign, followed by concrete actions to ma insurance schemes more explicit and bolster the insurance fund.

To minimize the moral implications of such arrangements, however, it is critical that guarantees be established transitional period, and that supervision of financial institutions simultaneously be steppIssues of moral hazard also need to be considered in authorities' actions in financial institution insolvency.

Supervisors have adopted varying approaches to i institutions, including mergers, purchases and assumptions, nationalization, and liquidat the authorities should have a general bias toward writing-off existing shareholders and management and directors of troubled institutions, such actions may need to be balanced arguments that current owners and management may be best positioned to achieve an effe work-out.Fourth, I think we should bear in mind that banking sector crises often are short-term aberrations, but usually are manifestations of longer-term structural problems. it is crucial that policymakers address not only the immediate stock of problem assets th bank/good bank' vehicles, but also structural problems, or weaknesses in core profitability from high overhead, low margins, and excessive regulatory costs.

To the extent that un problems are not addressed, the banking sector will remain vulnerable to future instabilityThus, at the same time as authorities seek to battle a crisis, they also compelled to undertake a range of longer-term reforms to banking sector infrastructure, mos in areas of accounting, disclosure, capital, and supervision and regulation.

These cha involve bringing domestic standards in line with international standards, and can involv trade-offs, in that, for example, fuller disclosure of problem loans may undermine confidence.Finally, the scale of banking sector problems in a number of countrie necessitated opening up the sector to significant foreign investment.

Clearly, such a co political tensions and possible domestic backlash.

Notwithstanding these concerns, ownership is both inevitable and positive as foreign capital brings not only additiona strength to a domestic banking sector, but also frequently needed technology and skills tra

## Overall summary of initiativesWhat has been the success of responses to recent banking crises?

While it premature to draw firm conclusions, based on the experience in Latin America and early ind from Asia, I believe that, on the whole, policy responses have been meaningful andstrengthened domestic safety and soundness considerably.

Let me briefly review the new, pos financial landscape in Latin America.Crises have left perhaps their greatest imprint on domestic financial system s Financial systems have generally experienced significant consolidation - leading to a less banking market - as weaker and more marginal players have been forced to exit.

Foreign capi accounts for a noteworthy share of banking assets across a number of countries, bringing financial strength and know-how.

Many governments have sought to reduce their direct role financial system through the privatization of state banks, although this will likely rema term policy objective for many countries.Authorities also have made tremendous strides in improving system infrastruc Disclosure standards have been greatly improved, and in some Latin American countries, dis standards are now comparable to that of G-10 countries.

Recognizing the greater historical in emerging market economies, minimum capital requirements have also been raised to levels Basle minima, and now incorporate additional sources of risk, such as market risk.

F supervision and regulation has been improved, with additional resources dedicated to the h training of examinations staff and to investments by regulators in information tec Authorities have been tested and have established more effective mechanisms for addr problem bank situations.Financial institutions have undertaken a range of measures themselves to im risk management practices, operational controls, and core profitability.

Some institut attempted to comply with international standards, notwithstanding lower domestic requir These reforms are especially important in light of the fact that the obligation to promo soundness rests mainly with financial institutions themselves.Taken together, these reforms indicate progress toward reduced systemic heightened competition, increased banking services provided to the domestic population, an standards of conduct better approximating international standards.

## Work AheadNotwithstanding

this progress, much work remains ahead.

While crises ha motivated a great deal of reform in individual countries, and standards are approaching in norms, the international financial system remains a patchwork of varying standards and gu While international disclosure standards have improved markedly in recent years, greater d still is required, particularly with respect to bank asset quality, both in emerging a countries alike.

In seeking to make these improvements, however, we should avoid a 'che approach which may not address the risks of a given country and may soon become outdated.Improved disclosure will require more than a comprehensive framework Accounting standards also need to be upgraded to reflect innovations in financial product management techniques.

The process of upgrading accounting standards, in turn, would benefi greater harmonization of accounting standards that would facilitate comparison of global institutions and result in more uniform capital standards across countries.At a fundamental level, I wonder whether the crisis has engendered the important reform of all - the development of a true credit 'culture'.

While necessarily a process, the existence of a sound credit culture is the sine qua non of long-term financial stability.

Improved disclosure requirements for nonperforming loans, for example, will be meaninglessextent that credit standards are weak to begin with, or that there is widespread toleran the restructuring of past-due loans, motivated by an unwillingness to admit that the troubled.

Further enhancements to the bankruptcy and legal codes to increase the effici transparency of collateral recovery are equally necessary.While supervisors have made tremendous strides to effect comprehensiv consolidated supervision globally, significant work remains to be done (and perhaps alwa The rapidly evolving international financial system, in which institutions operate to a gr across national borders through a variety of entities and, increasingly, in combination wi underwriting and insurance businesses, poses continued challenges to supervisory fram organized primarily on a national, legal-entity, and business-specific framework.

The ex parallel, offshore, and other unregulated structures also will continue to present obstacl implementation of comprehensive, consolidated supervision on a global basis.

Managing these will require intensified coordination and information-sharing among international supervisoAuthorities need to ensure that capital adequacy guidelines keep pace developments in internal risk measurement techniques and changes in the business of bank that end, the Basle Capital Accord's market risk amendment, which went into effect at 1997, represents a significant shift in capital supervision, moving away for the first t prevailing approach of a mandated and rigid regulatory formula or ratio.

The amendmen represents a major step toward a more market-based approach to supervision that draws on internal methodologies for risk measurement, places greater emphasis on promoting soun management and control processes, and encourages further innovation and improvement in banks' internal models.While the market risk amendment is a major step in the right direction, we begin thinking now about a conceptual framework for the next generation of capital particularly given the long lead times involved.

The original Basle Capital Accord took years to develop, and almost seven more years were required to reach agreement on the mar amendment.

I intend to do whatever I can as chairman of the Banking Supervision Committ raise the relevant issues and promote the development of new approaches to capital adeq early as possible.In discussing the challenges ahead, I should also note some recent accomplishm particularly the work of the BIS Committee on Payments and Settlements Systems, of which the former chair, on reducing Herstatt risk in foreign exchange settlements.

Previous wo Committee, embodied in a March 1996 report, recognized that settlement risk depends not o the payments system infrastructure, but also on the way market participants use this inf and manage their internal processes.

A follow-up report was issued one week ago that appla progress made, while noting that there were further opportunities for private sector in reducing settlement risk.

The central banks, of course, are ready to work closely with sector in achieving this goal.

## ClosingPreventing future banking crises poses difficult issues for policymakers.

Gi indispensable role that banks play in a nation's economic well-being, all governments have important that financial institutions be subject to regulation or oversight.

It is understand from the start, however, that there are limits to the supervisory process.

Supe limited ability, for example, to detect fraud.

Most important, in a market-oriented banki bank directors and management must have the ability to set the bank's overall course, treasonable profit, and to innovate and experiment with new banking activities and products words, supervision can not be so heavy-handed as to stifle competition and innovation.

As supervisory process has an inherent tension between the freedom banks need in order t reasonable profits and the latitude to take such large risks that their future could be e seeking reforms to supervision and regulation in response to financial system crisis, w ensure a proper balancing of these trade-offs.While I am broadly encouraged by the international policy responses to r financial crises, I recognize fully that more work remains to be done.

I look forward to these challenges in my new position on the Banking Supervision Committee, and to our con cooperation as we work together toward building a sounder international financial system.