William J McDonough: The review of the Capital Accord
Remarks by William J McDonough, President and Chief Executive Officer of the Federal Reserve
Bank of New York, before the Eleventh International Conference of Banking Supervisors, held in
Basel, 20-21 September 2000.
* * *
I am greatly honored to be here as Chairman of the Basel Committee on Banking Supervision. I'd like
to begin by thanking the Swiss National Bank, Kurt Hauri and the Swiss Federal Banking
Commission, and Andrew Crockett and the BIS for organizing and hosting this important conference.
They've done a wonderful job, for which I know we're all very grateful.
It is also a great pleasure to be with you under such dramatically different circumstances than when we
last gathered together. Just two years ago, turbulence in the financial markets around the world had
affected, in one way or another, the banking systems of virtually every nation, and bank supervisors
were struggling to preserve confidence and stability. Today, of course, the global financial situation is
much more stable and the outlook is very favorable.
In the United States, we continue to enjoy the longest economic expansion in our nation's history, and,
following passage of financial modernization legislation, banks and other financial institutions now
enjoy unprecedented strategic opportunities.
In Europe, following monetary union in January of 1999, the banking industry, along with other
corporate sectors, is becoming more efficient and competitive as economic and political reforms have
sharpened the focus on shareholder value.
In Asia, and in many emerging market economies, meaningful headway has been made toward
recapitalizing banking systems, ridding banks' balance sheets of problem assets, and improving
supervisory and regulatory frameworks. As a result, economies are growing again, equity markets
have rebounded, and foreign capital has begun to return. What a difference two years of hard work can
make.
When I last addressed this conference in October of 1998, I said that bank supervisors have a special
role in maintaining financial stability, and that our special role has two components: facilitating the
resolution of problems when they occur, and taking the necessary steps to lower the risk of problems
occurring. Two years ago we were busy with the first component - crisis management and resolution.
Today, as we stand on the threshold of a new century, we have the opportunity to focus on the second
- prevention.
With that in mind, it is my view that the greatest challenge to the long-term goal of financial stability,
both locally and globally, is the accelerating pace of change and financial innovation, driven by the
steady march of technological advancement. To be sure, such rapid change has created unprecedented
opportunities for both producers and consumers of financial products and services. But it must also be
acknowledged that with such remarkable progress has come new, more complex and potentially
farreaching risks.
I'd like to begin by addressing the profound impact of today's technology on banking and the financial
markets, then move on to the implications of that impact for effective supervision in the twenty-first
century. On the subject of official supervision, I will discuss the Basel Committee's Core Principles
for Effective Supervision, and then conclude with an update on the Committee's major initiative to
revise and refine the 1988 Capital Accord.
Technology changing the world, banking and supervision
It's been said that information is power. Whoever said that surely never had to deal with the flood of
e-mail most of us receive each day. Indeed, with increasing frequency, the complaint nowadays is
about "information overload." With wireless communications enabling us to conduct business
anytime, anywhere, I sometimes feel, as I'm sure many of you do, that no matter where I am in the
world, I'm expected to be awake and working.
For those who occasionally feel overwhelmed by technology's marvels, it's worth remembering that
there was a time, and not so long ago, when reliable market information was decidedly scarce and
concentrated in the hands of a privileged few. The Rothschilds built an international banking empire
on the wings of carrier pigeons, whose messages enabled the brothers to buy and sell on information
about investment opportunities or financial disasters in distant places long before their competitors
heard the news.
Today, information of all kinds is transmitted easily, inexpensively and instantaneously around the
world, providing finger-tip access to anyone with a laptop computer, cellular phone or palm pilot. As
but one example, I'd mention that, as of last month, the most popular items on the Federal Reserve's
public web site - including statistical reports on foreign exchange rates, selected interest rates,
consumer credit and industrial production, along with press releases and Federal Open Market
Committee announcements - are accessible by wireless remote.
If information is power, and it surely is, then a profound and irreversible transfer of power is
underway in the global financial marketplace - from providers of products and services to consumers.
For example, the Internet - something most of us had never heard of five years ago - is changing how
consumers shop for financial products and services, the prices they pay, and with which providers they
establish relationships.
In response, financial institutions, who once viewed technology mainly as a cost center, now see the
Internet and other technological capacities as strategic tools for enhancing the value of customer
relationship through cross-selling and improved customization. A recent survey of bank managers in
the United States reported that, for the first time, investment in Internet technology was cited as the
top budgetary priority, ahead of items such as investments in call-centers and brick-and-mortar
branches.
The growing importance of the Internet as a distribution channel is also eroding traditional barriers
between financial service providers and technology firms. Banks are increasingly providing
technology services, such as account reconciliation software and "web-enabling" assistance, while
technology firms are making inroads into services once the domain of banks and brokerage firms, such
as financial planning and bill payment. Indeed, many banks are beginning to think of technology firms
as competitors - or are contemplating ways to partner with them.
I'd guess that most of us, perhaps even all of us, consider the advancement of computing and
information technologies, and their role in the development of ever-more sophisticated financial
instruments and techniques, to be decidedly positive developments. Such technologies, and the
innovation they enable, have reduced the costs of financial transactions, improved the allocation of
financial resources, increased the competitiveness and efficiency of financial institutions and markets,
and opened new avenues through which individuals and institutions can better diversify and hedge
their risks.
But with this progress has also come new and difficult challenges. The rapid pace of technological
advancement and financial innovation has introduced new, highly complex elements of risk, increased
the speed and volatility of the markets, and blurred the barriers between previously distinct sectors of
the financial marketplace.
Even as supervisors confront change, the fundamental questions remain the same. Where is the risk in
banks' activities, and how effectively are they managing it? Where are banks extending credit and in
what form? Who are banks' customers, and how are those customers changing? To what extent are
credit risks being transformed into liquidity and operational risks?
The difference today is that the timeframe for answering these fundamental questions is dramatically
shortened. As supervisors, we must be able to look at rapidly changing financial institutions and assess
whether their strategies make sense and whether they are effectively evaluating the risks associated
with executing those strategies.
Technology and innovation have also rendered geographic boundaries all but meaningless, and
undermined the power and control of financial authorities. As you know, one of the principal means of
supervising internationally active banks has been the process whereby the host supervisor approves the
establishment of a brick-and-mortar presence in its country or jurisdiction. By way of a web-based
platform, banks can now target customers far beyond the reach of a typical branch, and even cross
borders into countries where they have no local offices and may never have conducted business
before. We've already seen a few cases in which a bank is chartered in one country, handles its data
processing in another, and targets customers in still others. Such situations will surely challenge
traditional notions of "home" and "host" supervisor, and raise difficult issues regarding international
coordination and cooperation, information sharing, law enforcement and privacy.
In a world of instantaneous communication, interconnected markets, and more complex instruments
and risks, effective supervision is more important than ever to maintaining financial stability, both
locally and globally. To remain effective and relevant, supervisors must understand how and to what
extent the "wired" economy and other technologies are changing banking and finance. At the same
time, we must take care that our efforts to ensure the safe and sound operation of the financial markets
do not stifle the innovation and creative energy that is changing banking and finance - indeed, the
world - for the better.
With these thoughts in mind, it is my firm conviction that to successfully meet the challenges of the
twenty-first century, our very notion of supervision, broadly speaking, must evolve to include financial
institutions themselves and the discipline applied by the marketplace.
Supervision in the twenty-first century
And so what is the purpose of supervision in the twenty-first century? What are the objectives, and
how can those objectives be best pursued?
Let me say first of all that there is no easy or single answer to these questions. The twenty-first century
financial marketplace is too dynamic, too complex, and supervisors must work within the political
realities of our respective nations. What I envision is a flexible, multi-faceted strategy that emphasizes
prudence and problem prevention, compatibility with the market, and a close and cooperative working
relationship between the private and public sector.
With these priorities in mind, I believe there are three essential elements of a modern supervision
framework:
• effective bank-level management;
• market discipline; and,
• official supervision.
Let me discuss each of these in turn, noting that each should reinforce the others to effectively
promote a safe and sound financial system.
Effective bank-level management
Primary responsibility for the safe and sound operation of a banking institution lies with its board of
directors and senior management. Boards of directors should oversee the development of the overall
strategy of the organization and the decisions made by senior management in pursuit of those strategic
objectives. In effectively executing these responsibilities, boards make a critical contribution to the
long-term success of the institution. This is a fundamental principal of banking that has not changed
with technological advancement. Indeed, if anything, the greater complexity and sophistication of the
modern financial services firm require more energy, effort and expertise from directors than ever
before.
I see two areas of board operation as being particularly crucial. First, banks and other financial
institutions must ensure that specific skills and competencies, consistent with the institution's strategic
focus, are represented on their boards. Institutions that engage in complex credit or market activities,
utilize sophisticated financial products, or expand their Internet or e-commerce capabilities, should
include one or more board directors with pertinent expertise in such areas.
Second, boards should establish clear guidelines regarding the independence of their directors.
Generally, it is desirable for at least some directors, and perhaps a majority, to be independent and
from outside the ranks of the management of the institution. Further, the board should set parameters
regarding at what point, or under what circumstances, a director's outside business interest becomes so
significant as to raise questions of a possible conflict.
Serious measures to ensure relevant competencies and independence will greatly enhance boards'
effectiveness and go a long way toward ensuring they perform their increasingly critical role in
overseeing the decisions of senior management.
The role of senior management, in turn, is to set the business strategy, oversee day-to-day decisions
made within the organization, and ensure their consistency with long-term objectives and policies as
determined by the board.
There are several aspects to effective bank-level management. First, I would underscore the
importance of good corporate governance, the basic elements of which include:
• Independent and competent outside directors, as I mentioned a moment ago;
• Capable and experienced management;
• A coherent corporate strategy and business plan; and,
• Clear lines of responsibility and accountability.
Together, these elements contribute to an overall operating process conducive to long-term health and
prosperity. A tightly run ship with a disciplined crew led by an experienced and competent cadre of
officers is far better able to survive a long journey that will inevitably confront sudden storms.
Closely related to good corporate governance and critical to any banking institution's well-being is a
rigorous internal control apparatus. Of course, effective internal control systems have always been
centrally important to sound banking. This point becomes clear if we consider for a moment their
basic purposes:
• To provide reasonable assurance that the bank's and its customers' assets are safeguarded,
that its information is timely and reliable, and that errors and irregularities are discovered
and corrected promptly;
• To promote the bank's operational efficiency; and,
• To ensure compliance with managerial policies, laws, regulations and sound fiduciary
principles.
With these purposes in mind, it is clear that the long-term success of any banking organization
depends on the effectiveness of its internal control apparatus.
And never has this been more true than today. As the activities of commercial banks have become
increasingly diverse and complex, internal controls have become critically important to the sound and
successful execution of banks' strategic objectives.
I want to stress this point as strongly as I can. As a former commercial banker myself, I know there is
a powerful temptation for management to focus its attention and resources on the front office - those
areas and individuals that generate profits for the institution. But if something goes wrong in the back
office, it can quickly become the most important aspect of a bank's operations. We've seen this time
and time again. It is essential that sufficient resources, staff and managerial attention are devoted to the
back office and internal audit functions.
Firmly rooted on the foundation of good corporate governance and rigorous internal controls is the
central importance of effective risk management. Banking by its very nature is a business of taking
calculated risks. If they didn't take risks, banks could not perform their essential functions in a market
economy. But sound banking also entails the prudent management of those unavoidable risks. Each
banking institution must have in place the technical systems and management processes necessary to
identify the risks associated with its activities - lending and otherwise - and to effectively measure,
monitor and control those risks.
But even if an institution has an effective risk management and control structure in place, that structure
must also be accompanied by an institutional management culture that ensures that written policies
and procedures are actually translated into practice, with buy-in at all staff levels. Ultimately, an
institution's culture is determined - once again - by the board of directors and the senior management
it chooses to install. Management must take active steps to ensure that its commitment to an operating
environment that includes effective risk management and rigorous controls filters down the line of the
organization.
To summarize, these aspects of effective bank level management - good corporate governance,
rigorous internal controls and effective risk management - represent the first and most important line
of defense against potential problems. And this will increasingly be the case as the activities of banks
and other financial institutions become more complex and more global.
Market discipline
After effective management at the bank level, the second line of defense against financial instability is
market discipline, which is an increasingly important ally of the official supervisor. When armed with
timely and meaningful information on banks' performance, market participants can, by way of their
investment and credit decisions, encourage bank managers and boards of directors to manage their risk
exposures soundly. Equally as important, market participants can penalize those institutions that do
not.
But, of course, effective market discipline is not possible without meaningful public disclosure. While
significant progress has been made in recent years, it unfortunately remains the case that disclosure
practices have not kept pace with the rapid changes in banks' business activities and risk exposures,
and with how these exposures are measured and managed.
For this situation to be fully remedied, notions of what is proprietary information and what should be
in the public domain must change. Knowing a company's appetite for risk and its approach to, and
methodologies for, managing risk is essential to understanding the risks of being a shareholder, a
creditor or a counterparty. All financial market participants should approach the issue of disclosure as
users of financial statements rather than as issuers.
There should be little question about the urgency of achieving dramatic progress in this area. Clearly, a
full appreciation of risk cannot be achieved without sufficient information. All of us know that there is
no greater enemy to financial stability than a loss of confidence - and nothing undermines confidence
more than a lack of reliable information. Discipline imposed by markets might not be pleasant, but
more, higher quality information - in a word, transparency - bolsters the confidence of depositors and
other creditors and therefore makes doing business easier and more secure for everyone.
Of course, progress on the disclosure front will be limited until accounting standards are enhanced to
ensure proper valuation and to reflect innovations over the past decade, both in terms of new products
and modern risk management techniques. Accounting systems serve a variety of purposes, but none
more important than helping creditors and investors make rigorous and clear-eyed decisions as to
which enterprises meet market tests of efficiency, competitiveness and profitability that are necessary
to fulfill their obligations. Sound accounting systems also enable investors to determine the value of
enterprises, and, in so doing, assist in attracting capital, both foreign and domestic. With these
important purposes in mind, ongoing efforts to enhance accounting standards worldwide should
continue and even intensify.
There is also a need for greater harmonization of accounting standards across countries. We simply
must get to a point where supervisors and market participants alike can analyze and compare all
internationally active financial institutions on a consistent basis. And it will not be possible to have
uniform capital standards until we have achieved some consistency in accounting standards across
countries. I applaud the significant progress being made by the International Accounting Standards
Committee and look forward to the continued cooperation between the Basel Committee and the IASC
toward achieving the goal of harmonization.
Official supervision
While effective bank level management and meaningful market discipline are crucial elements of an
overall strategy for promoting and preserving financial stability, neither can substitute for the critical
role played by official supervision. While banks perform functions that are indispensable to the
success of any market economy, these same functions, by their very nature, introduce risks that are
capable of undermining the prospects for such success.
This reality was acknowledged by Adam Smith over two centuries ago in his seminal tract The Wealth
of Nations. And it is with this fundamental reality in mind that governments have long recognized that
banking and other financial institutions must be subject to at least some form of regulation and official
oversight.
The reasons for official supervisory intervention in the banking and financial system can be summed
up as promoting financial stability and minimizing systemic risk. This is a broad mandate - to ensure
that markets operate in a fair, transparent, and efficient manner, and that participants comply with the
rules of the game. To successfully fulfill this critical responsibility, it is clear that the fundamental
approach, scope and methodologies of official supervision must evolve in line with the way financial
institutions manage their activities, which increasingly is along business lines rather than legal entities.
With this in mind, supervisors should continue efforts to develop a more dynamic, risk-focused and
process-oriented framework, reflecting the reality that banks and other financial institutions are
increasingly able to alter their risk profiles at will. By "risk-focused," I mean that supervisory
resources should be directed at the most material risks to which an institution and its capital are
exposed, given its array of business activities. By "process-oriented," I mean that examiners and
auditors should determine whether management processes and methodologies are sufficiently rigorous
and effective, given the institution's identified risks. Institutions that demonstrate a sound control
structure and effective management processes should be subject to less intrusive supervision than
institutions that do not have this essential infrastructure in place.
The Core Principles
Specific supervisory arrangements, practices and techniques vary from country to country depending
on differences in culture, financial system structure and internal political realities. The diversity of
practices notwithstanding, a set of basic principles has be identified that should guide all supervisors in
an increasingly interconnected, global financial marketplace.
In 1997 the Basel Committee on Bank Supervision issued a set of twenty-five Core Principles for
Effective Bank Supervision to serve as a benchmark against which the effectiveness of different
supervisory regimes can be assessed.
The Core Principles document brings together concisely all of the fundamental elements needed to
carry out effective bank supervision - a remarkable achievement in its own right. Equally important,
in my view, the document also balances the desire to set high standards for supervisory practices with
the pragmatic recognition that not all countries are in the same stage of financial market development.
As such, the Core Principles document is of particular importance for developing market economies,
as it establishes a clear set of standards against which any country's current approaches and progress
can be measured.
It should be emphasized that, in attempting to craft a document that would have the legitimacy, quality
and flexibility to meet the needs of bank supervisors around the world, the Committee made a
conscious effort to consult broadly throughout the various stages of the project, and particularly with
supervisors from emerging market nations. Only through an inclusive approach could we design
comprehensive principles with broad applicability and support.
In October of last year, the Basel Committee, in cooperation with the IMF and the World Bank,
produced a follow-up document called the Core Principles Methodology. This report was initiated in
response to requests from a number of countries for additional guidance on how to interpret and
implement the Core Principles. The Methodology document provides specific criteria for evaluating
and implementing each Core Principle. One set of criteria focuses on issues deemed essential for the
minimum implementation of the Core Principles; the other focuses on those issues deemed to
represent "best practice." The IMF and the World Bank currently use the new methodology to assess
the banking sectors in individual countries.
It should be stressed that the most important efforts to implement the Core Principles are occurring in
individual countries and, with this in mind, I am pleased to say that approximately 120 countries have
now endorsed the Core Principles. Without the support and backing of national authorities to follow
through with the implementation of these principles, our broader efforts simply cannot be effective.
In this connection, the Basel Committee has long recognized the need for effective training of
participants in the global supervision community, and over the years has sponsored numerous
programs which have been beneficial in allowing supervisors from different countries to share
experiences and exchange ideas for improved practices. In 1998, the Basel Committee, along with the
Bank for International Settlements, jointly established the Financial Stability Institute, which conducts
leadership seminars for supervisors in emerging market countries and facilitates technical assistance.
Effort to revise the Basel Accord
Let me move on to the Basel Committee's initiative to revise the 1988 Capital Accord. As you well
know, capital has been, and continues to be, an important supervisory tool.
Since 1988, capital regulation has evolved around a set of minimum ratios that were devised by the
Basel Committee on Banking Supervision and set forth in a document known as the Basel Accord.
The Accord was, without question, a milestone achievement - for the first time, supervisors were able
to use a common yardstick for assessing banks' capital adequacy. The development of risk-based
capital ratios has helped to strengthen capital standards in the more than 100 countries that adopted the
Accord.
In recent years, however, the Accord has exhibited serious shortcoming. One significant weakness is
that the Accord's broad brush structure may provide banks with an unintended incentive to take on
higher risk exposures without requiring them to hold a commensurate amount of capital. It also has not
kept pace with innovations in the way that banks measure, manage and mitigate risk.
With these concerns in mind, in June of 1999 the Basel Committee released a Consultative Paper for a
new capital adequacy framework. While we knew this paper would not represent a perfect framework
for all banks, our aim was to release a credible package that would serve as a basis for discussion. We
actively sought feedback from the industry worldwide during the formal comment period that ended
on 31 March of this year, and we are continuing this dialogue.
I should note that we are very pleased and encouraged by the more than 200 comments received from
a variety of sources, including financial institutions, central banks and supervisors, non-G10 countries
and other market participants. The respondents on the whole have sent us a strong endorsement of our
overall goal of developing a capital framework comprised of three pillars - minimum capital
standards, supervisory review and market discipline - that is more risk reflective and appropriate to
banks of varying levels of sophistication.
At the same time, the respondents raised a number of important concerns and questions that the
Committee is reviewing and considering carefully. The comments offered by emerging market and
other "non-G10" countries have figured prominently into the Committee's review of its initial
proposal, and Claes Norgren, who is chairing the next session, will provide an update on the
Committee's thinking regarding these points.
I'd like to take a few minutes to update you on our efforts, focusing on a few topics of special interest.
Given the progress we have already made, it is clear to me that the Committee is well positioned to
continue its momentum and to release a revised Consultative Paper early next year.
Internal ratings-based approach
The centerpiece of the new Accord is likely to be the internal ratings-based approach to credit risk. We
envision that the internal ratings method will be applicable to those institutions that have in place
strong internal rating systems accompanied by robust internal controls. Naturally, our new standards
will also encompass guidance on supervisory oversight and provide for ample disclosure.
The Committee is looking to establish standards that are rigorous and yet permit institutions willing to
make the necessary investments to use the approach. I think that it is fair to say that the Committee
now expects that many sophisticated institutions will seek to use the internal ratings-based approach.
How will an internal ratings-based approach work? Simply described, there are three components to
the internal ratings-based approach being developed by the Committee. First, a bank would assign
each of its loans or exposures to an internal grade, which reflects the risk associated to lending to each
borrower. A bank would do so by using the expert judgment of senior lenders and its own well-defined
internal rating scale and criteria. The bank would then assess the likelihood of default of borrowers in
each internal grade, based on its own analysis. Many larger banks are doing this now. It is this
assessment of the probability of default that is the core of the internal ratings-based approach.
The second step is for the bank to assess the severity of loss should a loan default - most often referred
to as the Loss Given Default. The Committee currently envisions two internal ratings-based
approaches, a foundation approach and an advanced approach with even higher minimum standards. A
key distinction is that under the foundation approach, banks would use supervisory estimates of
lossgiven-default based on loan characteristics, while under the advanced approach, they could make use
of their own analysis.
The third step is to derive the bank's capital requirement. The Committee will set out the risk weights
that correspond to different estimated probabilities of default and loss-given-default. These risk
weights are being developed by the Committee as a measure of unexpected loss, reflecting the amount
of potential credit loss for each loan.
A key aspect of the internal ratings-based approach is the development of rigorous supervisory
standards for the assignment and quantification of internal ratings. An essential component of these
standards is the so-called "use test" that requires a system of internal ratings to be an integral part of a
bank's risk management and own assessment of capital adequacy. The internal reliance on these risk
ratings will not only help supervisors gain confidence in the accuracy of a bank's ratings system, but
will also provide a key link to the proposed second pillar of the Accord, supervisory review.
Other work on minimum capital requirements
While the focus of my remarks has been on the internal ratings-based approach, the Committee also is
working on other key aspects of the new framework, including revising the standardized approach,
developing an expanded treatment of credit risk mitigation techniques and assessing a capital charge
for operational risk.
Standardized approach
The Basel Committee remains dedicated to revising the standardized approach as banks and
supervisors in some countries may not yet have the necessary resources to implement an internal
ratings-based method. To improve the risk sensitivity of the standardized approach, the Committee
sought to establish capital requirements that recognized some differences in the