Mr. Meyer reflects on recent developments in banking and financial markets: implications for bank supervision and regulation  (Central Bank Articles and Speeches, 18 Sep 98)
Central bank: fed | Type: speech | Date: 1998-09-18

Mr.

Meyer reflects on recent developments in banking and financial markets: implications for bank supervision and regulation Remarks by Mr. Laurence H.

Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Fin Institutions Center, University of Tennessee, Knoxville, on 18/9/98.The banking and financial services industries have been undergoing rapid c in recent years.

These changes include the consolidation and increased geographic scop banking industry, a blurring of the distinctions between various financial in deregulation, and the implementation of financial strategies made possible by improvem computer technology and advances in finance theory.

These changes in turn have create opportunities and risks for financial institutions and new challenges for superv regulators.My focus today will be on how legislation, supervisory practice and regu standards have to adapt to these changes in order to promote competition for financia and maintain stable financial systems.

Markets are moving very rapidly, while legisl regulatory changes are occurring much more slowly.

It is important that both legisla regulatory standards quickly catch up to the changes in the market place in order to ma benefits to consumers and minimize the risks to financial stability.There are three ways in which recent developments have put pressure legislation, regulatory standards and supervisory practice.

First, the job of supervisi become more challenging as a result of the increased size, geographic scope, comp globalization and diversity of banking organizations.

Second, the effectiveness of o foundations of the current regulatory framework, the risk-based capital rules, has improvements in credit risk measurement facilitated increased use of securitization derivatives to arbitrage those capital rules.

These innovations have allowed banks to capital charges for a given set of risks, making reported risk-based capital ratios inc meaningful and the current standards progressively less effective.

Third, banks a financial institutions, often with the help of their regulators, have found ways, a statutory limits, to expand not only the activities in which they engage, but also to c effectively with one another.

Market developments and regulatory actions have created with the existing legislative framework underpinning banking and financial services.I will focus on three policy responses.

First, I will discuss the pot increased market discipline to raise the overall effectiveness of the current reg supervisory framework, responding to the challenge of supervising such large and c institutions, without more burdensome and intrusive regulations.

Second, I will empha priority that needs to be attached to updating and refining our capital standards.

T discuss the importance of financial modernization legislation.Before tackling the policy questions, let me begin by reviewing why and banks are regulated.

## Why Do We Regulate Banks?Why do we supervise and regulate banks?

The reasons are very straightforw Initially, when banks were the dominant financial institutions, the major purpose was 'systemic risk' and the impact on the economy of bank failure.

Then as the safetycreated to reduce systemic risk, the resultant moral hazard created an even more import to supervise and regulate banks.Historically, the objective was to protect against a panic-driven flight to or bank runs, that caused a catastrophic decrease in the money supply and the col financial intermediation.

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

But l solvency problems at large banks and other financial institutions can create systemic and while banks are no longer 'special' the large banks do play a central role in ou system.

Indeed, the stability of the electronic, large dollar payments system, whi trillions of dollars a day and in which banks play a pivotal role, is critical in li risk.

Other potential pressure points, in all of which banks play a key role, include t 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 tha 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 as 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 priced, i for us to monitor and sometimes to act to control bank risks in order to protect the p on taxpayer funds.

An equally important, if unintended, consequence of the safety net creates what economists term 'moral hazard' incentives for some banks to take excessiv That is, the safety net creates incentives for banks to take larger risks than otherwis safety net, and potentially taxpayers, may absorb most of the losses if the gamble f incentives are especially strong if the bank is near failure since, at this point, ban have virtually nothing to lose.

## How Do We Regulate Banks?Bank regulation and supervision can be thought of as a portfolio of regu rules

and supervisory practices that collectively aim to monitor and protect the soundness of the banking system, so as to control systemic risk, offset moral hazard i and limit the potential call on the taxpayer.

This portfolio includes, in no particular set of rules and practices relating to the federal safety net itself; (2) the re disclosure and the incentives that promote market discipline of banking organizations rules that govern the capital that banking organizations must hold; (4) the limi activities that banking organizations may engage in; (5) the restrictions on wher activities can be conducted within banking organizations; (6) prudential restrictio relationship between banks and their affiliates; and (7) the nature and details of the of banking organizations.The more effective is market discipline and the more effective are c standards, the less there is a need to invoke the more intrusive and burdensome compo the regulatory portfolio.

For this reason, I focus particularly on enhanced market dis reform of capital standards.

But financial modernization legislation has also focused a the role of activity limitations, restrictions on where activities are conducted withi organization, and the appropriate supervisory framework for more diversified financia organizations that would emerge from such legislation.

## Market Discipline: The Role of Subordinated DebtTo a significant extent, market discipline and regulatory standards are sub The

more effective the former, the less reliance has to be made of the latter.

B regulatory approach involves significant costs to both the private and public sectors reliance on the market can reduce the cost of achieving a given degree of safety and so the banking system and thereby increase the efficiency of the overall regulatory framewoBut there is a significant trade-off to worry about.

A greater reliance on t may also increase systemic risk.

For example, eliminating deposit insurance would c increase the incentive for depositors to monitor the risk profiles of banks.

The pri increased market discipline, however, would, in my view, be unacceptably high -- a sign increased risk of bank runs and hence systemic risk.

The key therefore is to find oppor increase market discipline in a way that results in an acceptable trade-off with respec risk and thereby to achieve the optimal balance of market discipline and regulatory stanMarket discipline involves information and incentives.

Markets need acces information to judge the risk profiles of banking organizations.

But, to make market work, there also have to be incentives for banks to respond to the changing judgmen market.It may be possible to increase market discipline by requiring large, intern active banks to issue a minimum amount of certain types of subordinated debt to the pu appealing aspect of this approach is that subordinated debt holders, so long as they a 'insiders', face only downside risk, and thus their risk preferences are very close to FDIC.

Subordinated debt holders would therefore be expected to impose market discipline bank that is quite consistent with what bank supervisors are trying to do, including e banks to disclose more information about their financial condition.

Observed risk prem subordinated debt could perhaps be used to help the FDIC set more accurate risk-based insurance premiums, and such debt would provide an extra cushion of protection for tax An additional benefit of having subordinated debt traded on the open market is th movements would provide a clear signal of the market's evaluation of the bank's fi condition that, even if it were not used to help price deposit insurance, could serve warning aid to supervisors.Such an approach would most likely be limited to the largest banks for at le reasons.

First, it is the increased size of banking organizations and the financial i the largest and most sophisticated banks that are challenging the effectiveness of regulatory and supervisory framework.

It may therefore be appropriate, even essen differentiate the regulatory standards and supervisory practices at large, sophist internationally active banks -- the predominant sources of systemic risk -- from those to small and medium-sized banks.

Second, it is unclear just how deep and liquid a m bank subordinated debt would be and what access small and medium sized banks would hav this market.

Today, almost no smaller banks, for example, issue subordinated debt, majority of the largest banks already participate to some degree in this market.

Howeve the largest banks that participate, most of their subordinated debt appears to be he holding company, not by independent third parties.

This suggests that the developmen operationally feasible program for mandatory subordinated debt would require a consi amount of careful thought.

Still, in my judgment it is thought that might prove very wor

## Reform of the Basle Accord: Updating Risk-Based Capital RulesCapital supplements the discipline from 'outsiders' -- the market -- by rei the

incentives of 'insiders' -- the owners.

Capital standards have therefore long foundation of the regulatory approach to safety and soundness in the banking system.The current capital standards are based on the Basle Accord adopted in 19 most of the world's industrialized nations in an effort to encourage stronger capita banks, to include off-balance sheet exposures in the assessment of capital adequacy establish more consistent capital standards across nations.

The Accord was a major ad 1988, and has proved to be very useful since then.

But in recent years calls for reform to grow.The Basle Accord capital standard divides bank on- and off-balance-sheet a into four risk buckets, and then applies a different capital weight to each bucket.

Th are intended to increase with the riskiness of the assets in a given bucket.

How relationship is rough.

Perhaps most troublesome, the same risk weight is applied non-mortgage loans.

Thus, for example, a loan to a very risky 'junk bond' company ge same weight as a loan to a 'triple A' rated firm.While the current capital rules fail to differentiate among the riskiness o the banking book, banks are increasingly doing so, taking advantage of increasingly models for measuring, managing, and pricing risk.

These models allow banks to assign i economic capital to the various loans and allow banks to identify those loans for economic capital is less than that required by the Basle Accord.

Banks should then eith remove loans from their banking books for which regulatory capital exceeds economic cap otherwise find ways to make regulatory capital converge to economic capital.

Conversely should want to keep loans that their models assign higher capital than required by standard.

And, banks have been doing just that, in part through innovations such as sec of loans and credit derivatives.Banks use securitization, for example, to remove their lower risk loans perhaps they otherwise would not originate -- from their banking books, reducing the a capital charges.

In a traditional securitization, a special purpose vehicle sells secur a loan pool and uses the proceeds to purchase the loans from the bank.

There might se no problem with this arrangement, as long as banks shed the risks that go along with th this were the case, securitization would simply be a device for shifting to the capita risks associated with the bank loans securitized.

Banks would then continue their tradi of originating the loans, but the capital markets would play an increased role in the fu loans.But, in reality, banks are required to keep part of the risk or provide s enhancement in order to make the securities backed by the loans more acceptable to th market.

Thus securitizations typically result in only a limited transference of risk. capital rules typically reduce capital requirements against the retained bank exposur than banks lower the risk associated with the underlying loan pool.

In addition, even completely transferred the risk associated with the underlying loan pool, eliminating t loans from the banking book raises the average risk level of the remaining loan portfol a question as to whether the 8% capital charge remains adequate.Credit derivatives are another technique for managing both risk and risk capital charges.

Derivatives are ways of slicing and dicing the risks and returns of a the risks and returns can be allocated more efficiently among ultimate risk takers.

Wi derivative, a bank can transfer the risk and returns associated with a loan, even tho accounting perspective the loan remains on the books of the bank.

By using credit der banks can create 'synthetic securitizations' to transfer risk and reduce risk-bas requirements, while avoiding disclosure of an effective loan sale and possibly ha customer relationship.

Such arrangements are also typically less costly than tr securitizations in terms of administrative, legal, and other structuring costs.

As wi securitizations, the concern from a regulatory perspective is that a bank is encourage the risk-based capital requirement associated primarily with higher quality assets. questions about its overall capital adequacy, given the remaining risks in its portfoliThis so-called 'regulatory arbitrage' may not be all bad.

It arises, aft response to deficiencies of the capital standards themselves, specifically their fail differences in the risk of loans within and across banks.

Given the intense competiti banks, in part due to the globalization of the banking industry, banks are under press their capital and thereby raise their profitability.

When regulatory capital requi significantly greater than the economic capital banks would otherwise assign to a gi banks either have to find ways to lower those capital charges, shift the risks associat loans elsewhere, or get out of the business of making such high quality loans.

In the such adjustments, the capital standards might otherwise drive banks out of the bus making high quality loans and therefore toward increased risk-taking.

Regulatory arbitrage can therefore be a safety valve that allows banks to continue in the busines to high quality counterparties.But we must deal with both the problem of the degree to which the capital remaining credit risk at a bank associated with securitizations accurately reflect Perhaps even more critical is addressing the effect of both securitizations and credit for the capital associated with the risk level of the residual loan portfolio.

A on regulatory capital charge and the cherry-picking of securitizing low risks and retainin is, I believe, our biggest problem with securitizations -- real and synthetic.

To a problems we need a two-track approach.

In the near term, we need to implement rules tha match capital charges with the residual risk left after securitizations.

This is a problem.

The banking agencies issued a proposed rulemaking to address this issue in No of 1997 and received many comments from the industry.

A high priority in the near term putting in place an improved set of rules related to securitization.Over the intermediate term, we need to move more rapidly toward reform of Basle capital standards, with a particular emphasis of dealing more effectively with risk in the banking portfolio.

This hopefully would reduce or eliminate the incentiv low-risk assets out of the banking book and, in any case, permit capital charges to b systematically in relation to the risk in a given banking book.

Because the markets are rapidly, this has to be a high priority.

Because these standards require internation and because the problem is complex and the solutions not entirely self-evident, the reform moves more slowly.

But the time has come for putting this effort on the fast tracFinancial Modernization: Updating the Legislative FrameworkAs opposed to being on the fast track, I believe we can all agree that, in States, reform of our legal framework for banking regulation and supervision has been slow track.

Indeed, much of our legal framework has essentially not changed since the the meantime, the distinctions between financial institutions has become increasingly b financial institutions have endeavored to broaden the activities they engage in to tak of synergies among the activities and to compete with other financial institutions.

Th been a relentless search for loopholes by the financial institutions and efforts b authorities to find ways within their charter to permit new activities in order to competitiveness of the institutions under their charge.

This process is not only ine creates new inequities, institutions that may be producing unintended risks, and the mi of resources.

That is why my colleagues and I are such strong supporters of H.R.

Financial Modernization Act of 1998, which the House passed last month and the Se Banking Committee approved in a modified form last week.Both bills bring our financial institutions into the 21st century in a fram minimizes risks and inequities.

The task it sets for itself is not easy.

First and for would finally let financial institutions get into each other's businesses, and thus wi and range over which institutions can compete for the public's business.

Mind you, thi statement that says financial supermarkets and/or large institutions will be bette successful than specialized and/or smaller institutions.

But the benefit is that th regulators, will decide which will prosper as competitors all bend their efforts t consumer.That is the bottom line.

It's the reason why there should be fin modernization.

But the bills also establish a structure of bank supervision that is co with efficient resource allocation and with minimizing risk to the stability of the e the taxpayer.

The key elements to that structure are some residual limits on bank limitations on the location within the banking organization where the new activitie conducted, a blending of functional and umbrella supervision, and the continuation of t Reserve's role in the consolidated supervision of banking organizations.Both the House and the Senate versions would permit banks to conduct in t own subsidiaries (so-called operating subsidiaries or 'op subs') only the same activiti may already conduct in the bank and financial agency activities, which by their natur minimal funding and create minimal risk.

These limitations, it seems to me, are cr several reasons.

Banks have a lower cost of funds than other financial entities beca safety net.

As I discussed earlier, this federal safety net, and the subsidy that goes are provided by the Government in order to buy systemic stability.

But it has a cost: risk taking by banks, reduced market discipline, and consequently the need for more bank supervision in order to balance the resultant moral hazard.

The last thing we shou to extend that subsidy over a wider range of activities, which is, I believe, exactly happen if bank op subs could engage in wider nonbank financial activities.

Not only wo increase the moral hazard -- and the need for bank-like supervision -- but it would als the competitive playing field between bank subs and independent firms engaging in th business, a strange result for legislation whose ultimate purpose is to increase the co financial services.Both bills would require that organizations that conduct both banking and financial businesses organize in a holding company form where the bank and the other a are both subs of the holding company.

Profits and losses of the business lines accrholding company and thus do not directly benefit nor endanger the bank, the safety ne taxpayer.

The safety net subsidy is not directly available to the holding company aff competition is thus more balanced.

Moreover, traditional regulators like the SEC and insurance commissioners still regulate the entities engaged in nonbank activities as i independent firms.

Functional regulation is desirable not only for competitive equity political necessity and a practical reality in the process of balancing that is req financial modernization.

In principle, functional regulation could also be applied to the safety net, I submit, would soon create regulatory conflict with that structure.Importantly, both bills would prohibit commercial affiliations with banks. no doubt that it is becoming increasingly difficult to draw a bright line that separa services from nonfinancial businesses; it will only become more difficult to do so.

Bu is that we are not sure enough of the implications of combining banking and comme potential conflicts of interest, concentration of power, and safety net and stability move forward in this area.

Better, I think, to digest financial reform before moving in will be very difficult to reverse.Finally, the holding company framework of the bills would keep the Fede Reserve as the umbrella supervisor.

I believe that the Fed has an important role t banking supervision in order to carry out its responsibilities for monetary policy, stabilization, and crisis management.

I cannot grasp how we could possibly understand happening in banking markets, what innovations are occurring and their implications, nature and quality of the risk exposures and controls so critical for crisis management formulation without the hands-on practical exposure that comes from supervision.

An um supervisor is needed for complex organizations in order to assure that the entire organ its policies and controls are well managed and consistent with financial stability.

At large organizations, I believe that supervisor should be the Federal Reserve so that w our role as a central bank and international crisis manager.

## ConclusionThe

rapid changes in banking and financial services markets are crea opportunities and challenges.

Increased competition in the financial services indu increased synergies provided by financial services firms promise important bene consumers.

But the increased size, breadth, complexity, and geographic scope of banki increased the challenge of managing and of regulating and supervising banks.

Banks responded by developing new approaches to measuring and managing risk.

Now it is tim regulatory standards and supervisory practice to catch up.

This catching up must updating the legislative framework underlying banking.

It must also involve updat international capital standards that have been the foundation of the regulatory framewo may also be useful to reinforce the role of market discipline.

Working together, the m political process, and the regulators can ensure that we take advantage of the new opp while maintaining the safety and soundness of our banking system.