Mr Ferguson discusses the evolution of financial institutions and markets: implications
for public and private policies and practices
Remarks by Mr Roger W Ferguson Jr, a member of the Board of Governors of the US Federal
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 implications of the
rapid and ongoing evolution of our financial institutions and markets. New financial
instruments, innovations in portfolio management, and the technological capability of
implementing new risk management strategies offer opportunities to reduce risk and to
improve efficiency by allocating risk to those most willing to accept it. Reductions of trade
barriers and the freer flow of financial capital around the world mean better resource
allocation, improved productivity, and higher standards of living for citizens of the United
States and many other nations.
While the current and potential benefits of financial and technological change are real and
substantial, they do not come without some costs. For example, the rapid pace of
technological change and the wide array of innovative financing techniques have in some
ways made it more difficult for outside investors and policymakers to evaluate the risks borne
by individual institutions and the broader markets. And, nearly instantaneous communications
and heightened interdependencies among nations speed the effects of poor investment and
policy decisions around the globe. Recent experiences in Asia, Russia, Latin America, and at
home have taught us a lot about the risks of an increasingly interdependent world linked by
complex financial relationships.
In this rapidly evolving world of inevitable benefits and costs, the key question for both
financial policymakers and market participants is: How can we retain the benefits of rapid
technological and financial innovation and of freer movements of goods and financial capital
across national borders, while simultaneously protecting our financial institutions and markets
from the risks that these changes might bring? This is not a new question, and I am sure that
most of this audience is well aware that many efforts are under way in both the public and
private sectors to address the variety of issues that this question evokes. As always, there are
no simple answers. But I believe that a number of fundamental principles have emerged that
should be used to help shape both public and private policies and practices.
Private Market Discipline Is the First Line of Defense
Perhaps the most fundamental principle that must guide us is that private market participants
are the first line of defense against excessive private and public risk in the financial system.
Private borrowers, lenders, investors, institutions, traders, brokers, exchanges, and clearing
systems all have huge stakes in containing their risks as individual agents and risks to the
system as a whole. Private market participants can discourage excessive risk taking by
choosing to do business with those firms that demonstrate sound risk management systems
and portfolios that balance appropriately risk and expected return.
If private markets are going to perform their risk control functions, then market prices must
send the right signals to all participants about the risks and rewards of a particular transaction
or at a given firm. In order to improve the ability of market prices to accurately reflect risks
and returns, I believe that we should take action ourselves and encourage action by others in at
least three areas.
First, we should seek ways of improving the transparency of financial institutions and
markets. As we all know, full information is a fundamental requirement of free and
competitive markets. More particularly, financial institutions and individual investors must be
well informed about their own and their counterparties' exposures, the nature of new financial
instruments, and the extent of overall market liquidity. I believe that banks and other financial
institutions could significantly improve their disclosures by providing more information to the
market about their risk management policies and practices and about the values of internal
risk measures. At present, the market seems to grant great weight to bank regulatory capital
ratios that are only crude indicators of an institution's risk profile. That attention is driven in
large part by the fact that these regulatory measures provide a consistent basis for comparison.
The regulatory and financial communities should work together to identify more meaningful
statistics to meet the market's needs.
At the international level much work is being done, and much remains. One of the key lessons
of our most recent financial crises is that international accounting and public disclosure
standards are often inadequate. An important step forward was the publication last November
by the international Basle Committee on Banking Supervision of guidelines for enhancing
bank transparency. That report provides guidance to banks and banking supervisors around
the world on the nature of core disclosures that should be provided to the public. Much more,
however, should be done to provide the public and supervisors with the information they need
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 regard, I
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 seriously.
Perhaps it would be useful to review briefly what the law says. FDICIA requires that,
regardless of the size of a bank, the bank resolution method chosen by the FDIC be the least
costly of all possible methods for meeting the FDIC's obligation to protect insured deposits. In
addition, FDICIA prohibits the FDIC from assisting uninsured depositors and creditors, or
shareholders of an insured depository institution. Add to these FDICIA provisions the
depositor preference provisions in the Omnibus Budget Reconciliation Act of 1993, and you
have some rather potent reasons for the market to be disciplined in its dealings with insured
depositories.
The only exception to these obligations is the so-called "systemic risk exception." But the
systemic risk exception is quite tough and explicit. It requires concurrence by two-thirds of
the Federal Reserve Board, two-thirds of the FDIC Board, and the Secretary of Treasury in
consultation with the President that conformance with least-cost resolution would "have
serious adverse effects on economic conditions or financial activity" before the FDIC is
allowed to "take other action or provide assistance as necessary to avoid or mitigate such
effects." In addition, if the systemic risk exception is used, any insurance fund losses arising
from such exceptional actions must be recovered through special assessments on all
depository institutions that are members of the relevant federal deposit insurance fund. Lastly,
the Comptroller General must subsequently review the agencies' actions and report its
findings to Congress. The sum total of these conditions establishes, in my view, a rather high
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-to-fail.
Nonetheless, the obvious need for the central bank and other government agencies to prevent
a systemic collapse of the banking and financial system, the creation of seemingly ever-larger
financial organizations, and the inherent uncertainties involved in the management of any
crisis leave room for doubt in some observers' minds. Perhaps by its very nature this is an
issue that can never be fully resolved. But it seems clear to me that any institution, regardless
of size, can fail in the sense that existing stockholders can lose their total investment, existing
management can be replaced, and uninsured creditors can suffer losses. In some cases it may
be necessary for an institution to stay in operation and be wound down in an orderly way over
a transition period. Ultimately, the institution could be sold in whole or in part. But even in
such cases the expectation of owners, managers, and uninsured creditors should be that real
and significant losses will be incurred. In my judgment, if policies consistent with these
principles are followed, then we will have eliminated much of the moral hazard associated
with the federal safety net for depository institutions while simultaneously being able to
achieve our goal of preserving financial stability.
One way to enhance the ability of market participants to limit risk taking by banks might be to
require at least the largest and most complex banks to issue a minimum amount of
subordinated debt. Many such proposals have surfaced over the last decade, including some
from within the Federal Reserve System. And while I think that it is premature to endorse any
one proposal, indeed there are a number of thorny details that would need to be worked out, I
am strongly attracted to the basic concept advanced by proponents of subordinated debt.
The fundamental notion behind requiring at least some banks to issue traded subordinated
debt is to create a set of uninsured bank creditors whose risk preferences are similar to those
of bank supervisors. Because subordinated debt holders have downside risk, but virtually no
upside potential, subordinated debt holders tend to be risk averse in much the same way as is
the FDIC. Thus, when a bank sought to issue subordinated debt the price that investors were
willing to pay would bring direct market discipline aimed at controlling excessive risk taking
by the bank. A second key objective is to create a set of market instruments that would
provide clear, and frequent, signals of the market's evaluation of a bank's financial condition.
Such signals could act as a deterrent to a bank's tendency to take excessive risk, and could
perhaps alert bank supervisors to examine, or otherwise intervene in, a bank more quickly
than they otherwise would. Changes in the market prices of traded bank subordinated debt,
and perhaps other actions by the owners of this debt, have the potential to provide such
signals. In this way subordinated debt could be used to bring indirect market discipline on a
bank.
Supervisory Discipline Must Be An Effective and Dynamic Second Line of Defense
While market discipline must be our first line of defense for ensuring financial stability, bank
supervision also has an important role to play. The very nature of a systemic disruption, which
imposes costs on not only the perpetrators, but also on many and diverse economic agents far
removed from the immediate event, means that market participants find it impossible to fully
incorporate systemic risks into market prices. Indeed, it is this very aspect of systemic risk that
justifies the existence of a government safety net for depository institutions. The inevitable
moral hazard of the safety net requires that bank supervisors have the ability to exert
supervisory discipline on the riskiness of banks.
I would like to comment tonight on what I consider two of the most pressing needs in the
bank supervisory area: the need to make capital standards more risk sensitive, and the need to
focus supervisory practice more on risk measurement and management.
I need not explain to this audience why the maintenance of strong capital positions is critical
to the preservation of a safe and sound banking system. Indeed, ensuring strong capital has
been a cornerstone of bank supervision for decades. However, the development by some of
our largest and most complex banks of increasingly sophisticated models for measuring,
managing, and pricing risk has called into question the continuing usefulness of the current
capital standards - the so-called risk-based capital standards - that are part of the Basle
Accord. The Basle Accord capital standards were adopted in 1988 by most of the world's
industrialized nations in an effort to encourage stronger capital at riskier banks, to include
offbalance sheet exposures in the assessment of capital adequacy, and to establish more
consistent capital standards across nations. The Accord was a major advance in 1988, and
initially proved to be very useful in promoting safety and soundness goals. But in recent years
calls for reform have begun to grow. I will outline briefly one of the key problems we are
currently facing with the Basle Accord.
The Basle Accord divides on- and off-balance sheet assets of banks into four risk buckets, and
then applies a different capital weight to each bucket. The basic idea is that more capital
should be required to be held against riskier assets. However, the relationship is rough.
Perhaps most troublesome, the same risk weight is applied to all loans. Thus, for example, a
loan to a very risky "junk bond" company gets the same weight as a loan to a "triple A" rated
firm.
While the Accord has the virtue of being relatively easy to administer, it also clearly gives
banks an incentive to sell or not to originate loans that their internal models say need less
capital than is required by the Basle Accord. Conversely, banks are encouraged to book loans
that their models say require more capital than does the Basle standard. Not surprisingly, some
banks have devoted substantial resources to attempting to achieve both adjustments to their
portfolios. The resulting "regulatory arbitrage" surely causes some serious problems. For one
thing, it makes reported capital ratios - a key measure of bank soundness used by supervisors
and investors - less meaningful for government supervisors and private analysts.
Efforts are currently under way to redress many of the deficiencies in the current Basle
Accord. But many of the issues are complex, and the optimal changes are still unclear. A
consensus does seem to have developed that the Accord must be more risk sensitive. But how
risk sensitive, and how should that risk sensitivity best be implemented? I foresee a
multistaged process with perhaps some modest and relatively noncontroversial "fixes" being
proposed, possibly in the very near future, and more fundamental reforms being developed
and implemented over a period of several years. Given the dynamic nature of change in the
financial sector, such a phased, or evolutionary, approach to revising the Accord is probably
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 other
supervisory policies and procedures. For example, the increasing use and sophistication of
credit risk models at the largest and most complex domestic and foreign banks has profound
implications for supervisory activities as well as capital regulation. Understanding and
evaluating credit risk models and related risk measurement techniques are quickly becoming
required skills of bank supervisors. This need is fueled by the ever-growing array of
securitizations, credit derivatives, remote originations, financial guarantees, and a seemingly
endless stream of other financial innovations. Add to this the fantastic speed with which
financial transactions can now be conducted, and one begins to get a feel for the many
challenges facing bank supervisors.
With these realities in mind, supervisory practices at all of the banking agencies are changing.
Oversight of banks has become much more continuous and risk-focused than even a few years
ago, especially at the largest and most complex organizations. It is recognized that we can no
longer rely on periodic on-site examinations to ensure that these large institutions are
operating in a safe and sound manner, but rather must be assured that their risk management
practices and internal controls are sound on an ongoing basis. Still, on-site examinations, in
my judgment, remain critical. However, on-site examinations must evolve to be both as
effective and as unobtrusive as possible. We are devoting substantial efforts to attracting,
training, retaining, and using effectively the highly skilled personnel that modern bank
examinations require.
The new procedures place greater importance on an institution's internal management
processes, beginning at the top. Consistent with the view that private agents are the first line
of defense against excessive risk, boards of directors are expected to be actively involved in
establishing the overall environment for taking risk, staying informed about the level of risks
and how they are managed and controlled, and making sure that senior management is capable
and has the resources it needs to be successful. Management is expected to develop and
implement the policies and procedures needed to conduct a banking business in a safe and
sound manner. Internal controls, evaluated by an independent internal auditing function, must
be sound.
Conclusion
I hope that my brief review of some of the key challenges facing economic policymakers and
private participants in banking and financial markets has convinced you, if indeed you needed
convincing, that these aspects of the modern world of finance are important, exciting, and
deserve the serious attention of all participants. The rewards, current and potential, of modern
banking and finance are great. But there are also some very real risks that we need to address
in effective, cooperative, and inevitably evolving ways.