Mr Ferguson discusses the evolution of financial institutions and markets: implications for public and private policies and practices  (Central Bank Articles and Speeches, 25 Feb 99)
Central bank: fed | Type: speech | Date: 1999-02-25

## Mr Ferguson discusses the evolution of financial institutions and markets: implicat for public and private policies and practicesRemarks by Mr Roger W Ferguson Jr, a member of the Board of Governors of the US Fede Reserve System, at the Money Marketeers of New York University, New York, on 25/2/99.This evening I would like to spend a few minutes discussing some of the implication rapid

and ongoing evolution of our financial institutions and markets.

New f instruments, innovations in portfolio management, and the technological capabi implementing new risk management strategies offer opportunities to reduce risk improve efficiency by allocating risk to those most willing to accept it.

Reductio barriers and the freer flow of financial capital around the world mean better allocation, improved productivity, and higher standards of living for citizens of States and many other nations.While the current and potential benefits of financial and technological change are substantial, they do not come without some costs.

For example, the rapid p technological change and the wide array of innovative financing techniques have i ways made it more difficult for outside investors and policymakers to evaluate the r by individual institutions and the broader markets.

And, nearly instantaneous commun and heightened interdependencies among nations speed the effects of poor investme policy decisions around the globe.

Recent experiences in Asia, Russia, Latin America home have taught us a lot about the risks of an increasingly interdependent world complex financial relationships.In this rapidly evolving world of inevitable benefits and costs, the key questio financial policymakers and market participants is: How can we retain the benefits technological and financial innovation and of freer movements of goods and financia across national borders, while simultaneously protecting our financial institutions from the risks that these changes might bring?

This is not a new question, and I am most of this audience is well aware that many efforts are under way in both the p private sectors to address the variety of issues that this question evokes.

As alwa no simple answers.

But I believe that a number of fundamental principles have emerg should be used to help shape both public and private policies and practices.

## Private Market Discipline Is the First Line of DefensePerhaps the most fundamental principle that must guide us is that private market pa are the first line of defense against excessive private and public risk in the fin Private borrowers, lenders, investors, institutions, traders, brokers,

exchanges, systems all have huge stakes in containing their risks as individual agents and r system as a whole.

Private market participants can discourage excessive risk ta choosing to do business with those firms that demonstrate sound risk management s and portfolios that balance appropriately risk and expected return.If private markets are going to perform their risk control functions, then market send the right signals to all participants about the risks and rewards of a particul or at a given firm.

In order to improve the ability of market prices to accurately and returns, I believe that we should take action ourselves and encourage action by o least three areas.First, we should seek ways of improving the transparency of financial institutions markets.

As we all know, full information is a fundamental requirement of free a competitive markets.

More particularly, financial institutions and individual investors m well informed about their own and their counterparties' exposures, the nature of new fina instruments, and the extent of overall market liquidity.

I believe that banks and other f institutions could significantly improve their disclosures by providing more information market about their risk management policies and practices and about the values of inte risk measures.

At present, the market seems to grant great weight to bank regulatory ca ratios that are only crude indicators of an institution's risk profile.

That attention i large part by the fact that these regulatory measures provide a consistent basis for comp The regulatory and financial communities should work together to identify more meaningfu statistics to meet the market's needs.At the international level much work is being done, and much remains.

One of the key less of our most recent financial crises is that international accounting and public disc standards are often inadequate.

An important step forward was the publication last Novem by the international Basle Committee on Banking Supervision of guidelines for enhancin bank transparency.

That report provides guidance to banks and banking supervisors aroun the world on the nature of core disclosures that should be provided to the public.

Much however, should be done to provide the public and supervisors with the information they n to exert effective market discipline.A second area where we could improve market discipline is in affecting how market participants view what has come to be known as the too-big-to-fail problem.

In this rega would emphasize that the FDIC Improvement Act of 1991, or FDICIA, contains rather tough language about too-big-to-fail - language that I assure you the Board takes very seriouslyPerhaps it would be useful to review briefly what the law says.

FDICIA requires th regardless of the size of a bank, the bank resolution method chosen by the FDIC be the costly of all possible methods for meeting the FDIC's obligation to protect insured depos addition, FDICIA prohibits the FDIC from assisting uninsured depositors and creditors, shareholders of an insured depository institution.

Add to these FDICIA provisions depositor preference provisions in the Omnibus Budget Reconciliation Act of 1993, and yo have some rather potent reasons for the market to be disciplined in its dealings with i depositories.The only exception to these obligations is the so-called 'systemic risk exception.' Bu systemic risk exception is quite tough and explicit.

It requires concurrence by two-thi the Federal Reserve Board, two-thirds of the FDIC Board, and the Secretary of Treasury consultation with the President that conformance with least-cost resolution would 'h serious adverse effects on economic conditions or financial activity' before the FDI allowed to 'take other action or provide assistance as necessary to avoid or mitigate effects.' In addition, if the systemic risk exception is used, any insurance fund losses from such exceptional actions must be recovered through special assessments on al depository institutions that are members of the relevant federal deposit insurance fund. the Comptroller General must subsequently review the agencies' actions and report findings to Congress.

The sum total of these conditions establishes, in my view, a rathe hurdle that must be cleared before the systemic risk exception can be used.The FDICIA and other reforms have, I believe, altered market perceptions of too-big Nonetheless, the obvious need for the central bank and other government agencies to a systemic collapse of the banking and financial system, the creation of seemingly e financial organizations, and the inherent uncertainties involved in the managemen crisis leave room for doubt in some observers' minds.

Perhaps by its very nature issue that can never be fully resolved.

But it seems clear to me that any institutio of size, can fail in the sense that existing stockholders can lose their total inves management can be replaced, and uninsured creditors can suffer losses.

In some case be necessary for an institution to stay in operation and be wound down in an orderly a transition period.

Ultimately, the institution could be sold in whole or in part such cases the expectation of owners, managers, and uninsured creditors should be and significant losses will be incurred.

In my judgment, if policies consistent principles are followed, then we will have eliminated much of the moral hazard as with the federal safety net for depository institutions while simultaneously bei achieve our goal of preserving financial stability.One way to enhance the ability of market participants to limit risk taking by banks require at least the largest and most complex banks to issue a minimum amou subordinated debt.

Many such proposals have surfaced over the last decade, includin from within the Federal Reserve System.

And while I think that it is premature to en one proposal, indeed there are a number of thorny details that would need to be work am strongly attracted to the basic concept advanced by proponents of subordinated debThe fundamental notion behind requiring at least some banks to issue traded subor debt is to create a set of uninsured bank creditors whose risk preferences are simi of bank supervisors.

Because subordinated debt holders have downside risk, but virt upside potential, subordinated debt holders tend to be risk averse in much the same the FDIC.

Thus, when a bank sought to issue subordinated debt the price that invest willing to pay would bring direct market discipline aimed at controlling excessive by the bank.

A second key objective is to create a set of market instruments th provide clear, and frequent, signals of the market's evaluation of a bank's financia Such signals could act as a deterrent to a bank's tendency to take excessive risk, perhaps alert bank supervisors to examine, or otherwise intervene in, a bank more than they otherwise would.

Changes in the market prices of traded bank subordinate and perhaps other actions by the owners of this debt, have the potential to pro signals.

In this way subordinated debt could be used to bring indirect market disci bank.

## Supervisory Discipline Must Be An Effective and Dynamic Second Line of DefenseWhile market discipline must be our first line of defense for ensuring financial sta supervision also has an important role to play.

The very nature of a systemic disrupt imposes costs on not only the perpetrators, but also on many and diverse economic ag removed from the immediate event, means that market participants find it impossible incorporate systemic risks into market prices.

Indeed, it is this very aspect of syst justifies the existence of a government safety net for depository institutions.

Th moral hazard of the safety net requires that bank supervisors have the ability supervisory discipline on the riskiness of banks.I would like to comment tonight on what I consider two of the most pressing needs in bank supervisory area: the need to make capital standards more risk sensitive, and the ne focus supervisory practice more on risk measurement and management.I need not explain to this audience why the maintenance of strong capital positions is c to the preservation of a safe and sound banking system.

Indeed, ensuring strong capital been a cornerstone of bank supervision for decades.

However, the development by some o our largest and most complex banks of increasingly sophisticated models for measurin managing, and pricing risk has called into question the continuing usefulness of the cu capital standards - the so-called risk-based capital standards - that are part of th Accord.

The Basle Accord capital standards were adopted in 1988 by most of the world' industrialized nations in an effort to encourage stronger capital at riskier banks, to in balance sheet exposures in the assessment of capital adequacy, and to establish m consistent capital standards across nations.

The Accord was a major advance in 1988, initially proved to be very useful in promoting safety and soundness goals.

But in recent calls for reform have begun to grow.

I will outline briefly one of the key problems w currently facing with the Basle Accord.The Basle Accord divides on- and off-balance sheet assets of banks into four risk buckets then applies a different capital weight to each bucket.

The basic idea is that more should be required to be held against riskier assets.

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

Thus, for examp loan to a very risky 'junk bond' company gets the same weight as a loan to a 'triple A' firm.While the Accord has the virtue of being relatively easy to administer, it also clearl banks an incentive to sell or not to originate loans that their internal models say n capital than is required by the Basle Accord.

Conversely, banks are encouraged to book l that their models say require more capital than does the Basle standard.

Not surprisingly banks have devoted substantial resources to attempting to achieve both adjustments to t portfolios.

The resulting 'regulatory arbitrage' surely causes some serious problems.

Fo thing, it makes reported capital ratios - a key measure of bank soundness used by superv and investors - less meaningful for government supervisors and private analysts.Efforts are currently under way to redress many of the deficiencies in the current Accord.

But many of the issues are complex, and the optimal changes are still unclear consensus does seem to have developed that the Accord must be more risk sensitive.

But ho risk sensitive, and how should that risk sensitivity best be implemented?

I foresee a staged process with perhaps some modest and relatively noncontroversial 'fixes' bein proposed, possibly in the very near future, and more fundamental reforms being develop and implemented over a period of several years.

Given the dynamic nature of change in t financial sector, such a phased, or evolutionary, approach to revising the Accord is pr not just the only practical strategy, but also the most prudent as well.The need for an evolutionary approach can be made with perhaps even more force to othe supervisory policies and procedures.

For example, the increasing use and sophisticatio credit risk models at the largest and most complex domestic and foreign banks has profo implications for supervisory activities as well as capital regulation.

Understandin evaluating credit risk models and related risk measurement techniques are quickly becomi required skills of bank supervisors.

This need is fueled by the ever-growing arrasecuritizations, credit derivatives, remote originations, financial guarantees, and endless stream of other financial innovations.

Add to this the fantastic speed w financial transactions can now be conducted, and one begins to get a feel for challenges facing bank supervisors.With these realities in mind, supervisory practices at all of the banking agencies a Oversight of banks has become much more continuous and risk-focused than even a few ago, especially at the largest and most complex organizations.

It is recognized that longer rely on periodic on-site examinations to ensure that these large instit operating in a safe and sound manner, but rather must be assured that their risk ma practices and internal controls are sound on an ongoing basis.

Still, on-site exam my judgment, remain critical.

However, on-site examinations must evolve to be bo effective and as unobtrusive as possible.

We are devoting substantial efforts to training, retaining, and using effectively the highly skilled personnel that mo examinations require.The new procedures place greater importance on an institution' s internal manag processes, beginning at the top.

Consistent with the view that private agents are t of defense against excessive risk, boards of directors are expected to be actively establishing the overall environment for taking risk, staying informed about the le and how they are managed and controlled, and making sure that senior management is ca and has the resources it needs to be successful.

Management is expected to deve implement the policies and procedures needed to conduct a banking business in a s sound manner.

Internal controls, evaluated by an independent internal auditing funct be sound.

## ConclusionI hope that my brief review of some of the key challenges facing economic policymake private participants in banking and financial markets has convinced you, if indeed y convincing, that these aspects of the modern world of finance are important, exci deserve the serious attention of all participants.

The rewards, current and potentia banking and finance are great.

But there are also some very real risks that we need in effective, cooperative, and inevitably evolving ways.