Mr. Meyer discusses financial globalization and efficient banking regulation
Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal
Reserve System, before the Annual Washington Conference of the Institute of International
Bankers in Washington, DC on 2/3/98.
The highly publicized recent events in the world's financial system have served to
make certain things abundantly clear. In particular, we now have further evidence that there is a
large and growing disparity between the risk management practices of what might be called the
"best practice" financial institutions and those of their competitors around the globe. This
disparity, moreover, runs much more deeply than the weaknesses exposed during the Asian
financial crisis. In that event, bankers were seen to make the kinds of basic mistakes that have
been oft repeated at other times and in other places. For example, loans were made to
government-supported enterprises, either at the behest of the government itself or under the
assumption that official support would be provided if the loans turned bad. At times, these loans
were made to highly leveraged companies whose underlying financial ratios did not justify the
origination of the loans on the terms under which they were made. To add insult to injury, the
offending banks sometimes borrowed in dollars and lent in their home currencies, without
hedging, believing that their government could and would continue to stabilize exchange rates.
While these practices are troublesome, I am much more concerned with what I
believe is both an exciting and disturbing aspect of the evolution of financial markets. Spurred
by improvements in computer technology and advances in financial theory -- most notably in
option-theoretic models -- new financial products, as well as the markets supporting traditional
banking products, are becoming ever more sophisticated and ever more global in nature. While
financial innovation and globalization can only be applauded for their salutary impact on market
efficiency, they present some difficult problems for market practitioners and, where the
practitioners are regulated entities, their supervisors.
Today, I should like to concentrate on three themes, or principles, related to the
evolution of financial markets: First, there exists a significant and dynamic connection running
between market innovation and market regulation. Financial innovation often occurs in response
to regulation, especially when such regulation does not make economic sense. Conversely, the
evolution of regulation often is spurred by advances in the market. Second, the globalization of
financial markets means that mistakes in risk management made by one or more significant
players in world markets can result in real losses not only to the entity making the mistake, but
also to other participants and to other countries' banking systems. Third, the economic
efficiencies that are potentially associated with financial innovation can be negated by inefficient
banking regulation. Efficient banking regulation, by contrast, not only provides the background
against which financial advances can occur, but also permits governments to achieve social
objectives where otherwise they might not, or might achieve them only at higher cost.
To demonstrate these three principles, we need discuss only one aspect of banking
regulation, albeit the most important -- namely prudential regulation as currently embodied
within the international capital standard for banks. The Basle Accord of 1988, while it was
critical to reversing the decades-long decline in bank capital ratios, has come under frequent and
strong attack in recent years, both by regulators and those that are regulated. In particular, there
is considerable concern that technological advances and rapid evolution in financial products are
reducing the meaningfulness and effectiveness of the capital standards, at least for the largest,
most sophisticated institutions.
The deficiencies of the Accord are well known, but bear repeating here: First,
while intended to be "risk-based", the formal capital ratio requirements nevertheless lump most
bank risk positions into a single "bucket" corresponding to a rather arbitrary, minimum total
capital requirement of 8 percent against the book value of the position. Second, the capital rules
do not explicitly account for certain risks that may be important, such as operating risk. Finally,
portfolio composition, hedging, and general portfolio management techniques are explicitly
considered only within the market risk requirements for trading account activities, not for the
credit or other risks that dominate within the banking book.
This arbitrary, one-size-fits-all minimum capital ratio has spurred what can only
be termed an avalanche of financial innovations aimed at either evading or taking advantage of
the capital standard. Such regulatory capital arbitrage, as we call it, currently is carried out
primarily via the securitization markets. While securitization may serve useful economic
purposes having nothing to do with regulatory arbitrage, a properly structured securitization
conduit can assist the sponsoring bank in lowering its effective regulatory capital requirement
against a group of assets or other risk positions. In many cases, the securitization results in the
bank retaining essentially all of the risk of the underlying assets, through the provision of credit
enhancements to the conduit, but at lower capital requirements than if the assets remained on the
bank's books. This is accomplished, for example, by having the conduit "remotely originate"
credits, thus allowing the bank to circumvent recourse capital requirements that apply only to
assets sold to the conduit. Alternatively, the bank can provide indirect credit enhancement to the
conduit by, for example, supplying backup lines of credit to the obligors that use the conduit to
raise funds.
To a significant degree, the growth in securitization and other forms of regulatory
arbitrage has been spurred by the inadequacies of the international capital standard. This has
occurred largely because, over the last decade, many of the larger banks have developed fairly
sophisticated internal models for formally quantifying risk, including credit risk within the
banking book. These models are used to calculate internal economic capital allocations for
various sub-portfolios of the bank, and it is because these internal capital allocations often differ
substantially from the 8 percent regulatory standard that the problems arise.
In the typical case, the bank attempts to formally measure each major type of risk
associated with a product or business line -- credit risk, market risk, and operating risk. In the
credit risk arena, for example, risk is measured as the estimated shape of a loss probability
distribution over a particular horizon, generally one year. Economic, as opposed to regulatory,
capital is then allocated against this loss distribution in an amount necessary to meet some
corporate goal for insolvency probability. For example, several large banks allocate enough
capital internally for credit risk so as to reduce to 0.03 percent the probability that credit losses
will exceed allocated capital. Why is this 3 basis point standard chosen? Because that is the
historical average default probability, over a one-year horizon, for double-A rated corporate
instruments. In other words, the banking firm wants to hold enough capital so that the chances of
it becoming insolvent are low enough to win a double-A rating on the bank's own liabilities.
The problem is that, when these economic capital calculations are made, they
result in a very wide range of internal capital allocations for individual positions or
sub-portfolios -- as low as several basis points up to more than 30 percent of the carrying value
of the risk position. When a group of loans is assigned an internal capital requirement that is
very low compared with the 8 percent regulatory standard, the bank has a strong incentive to
restructure the positions to allow them to be reclassified into a lower regulatory risk category, by
using securitization or other devices. If the bank doesn't do this, it cannot make a market rate of
return on the regulatory capital of 8 percent on the loans.
Regulatory arbitrage, from the perspective of proper resource allocation, can be a
good thing. If there were no way for the bank to avoid the uneconomically high regulatory
requirement, it would need eventually to exit its low risk businesses because of insufficient
returns to equity. In the long run, this would serve no purpose other than causing the regulated
entity to shrink in size relative to its unregulated competitor. At the extreme, the one-size-fits-all
capital standard, if there were no arbitrage safety valve, would cause the bank to engage in only
those activities for which the economic capital requirement is greater than the 8 percent
regulatory standard. That is, the regulatory standard would induce risk-taking -- perhaps
excessive risk-taking.
While regulatory arbitrage can be useful in negating improperly high regulatory
capital requirements, it can also be used to mask the true riskiness of the bank. In the United
States, for example, the top 50 bank holding companies have a mean total risk-based capital
ratio of 12.1 percent. The standard deviation of this ratio across the 50 institutions is only 0.8
percent. In other words, everyone seems to be holding about the same amount of capital. Indeed,
since a bank is declared to be "well-capitalized" when its total risk-based capital ratio is over 10
percent, it is not surprising that we see no top-50 banking company with its ratio less than 10
percent. But do all these banks have equally low insolvency probabilities? One simply can not
tell much of anything by looking at capital ratios. It is perfectly possible that a bank may hold 12
percent capital when a more carefully constructed internal risk model would call for holding 15
percent, or even 18 percent, capital to meet the bank's internal insolvency standard. Or, the bank
could have a great model, but simply have a preference for risk that is unacceptable to
regulators. Such a bank may be holding risky positions for which even its own model would call
for more capital, if the bank were to adhere to a lower insolvency probability standard. For such
a bank, the regulatory "well-capitalized" designation may provide little comfort to supervisors or
to the taxpayers we are supposed to protect. That is why, in this country, we have placed a great
emphasis on the bank-by-bank supervisory process, as opposed to the formal capital regulations
that apply to all banks.
Just as the most sophisticated large banks have gone through a rapid evolution of
their risk measurement, management, and pricing systems, so must supervisors follow suit. At
the Federal Reserve we have ongoing projects aimed at providing supervisors with better tools to
assess banks' internal risk systems and, ultimately, to make determinations regarding the real
adequacy of bank capital on a case-by-case basis. Among these efforts is a review of the credit
risk aspects of asset securitization at our major banking companies. Also, we are studying the
possible uses within the supervisory process for the internal rating systems used by almost all
large banks. In the past, supervisors made risk distinctions only among and between classified
assets, not pass assets. Now, we are studying the possibility that future deterioration in asset
quality can be foreseen to some extent by changes in the average rating, or the distribution of
ratings, in a bank's pass assets.
We are also spending considerable effort in tracking and understanding the
developments in risk modelling, including the modelling of credit risk. At last week's
conference on bank capital, hosted by the Federal Reserve, the Bank of England, and the Bank
of Japan, our economists discussed the prospects of moving to a full-fledged, models-based
approach to bank capital standards for the largest banks. In my personal view, moving from a
ratio-based capital standard to an internal models based standard for our most complex
institutions, should be high on our agenda. For the first time, we would be setting a maximum
insolvency probability standard rather than simply a minimum capital ratio. This may be the
only avenue before us if we wish to achieve an efficient regulatory system. In the absence of a
thorough revamping of the international capital standard, we will continue to be plagued by
regulatory capital ratios that, on the one hand, say little about insolvency probability, while on
the other hand induce banks to engage in sometimes inefficient regulatory arbitrage simply to
avoid an inherently uneconomic capital rule.
Please do not misinterpret my remarks. I believe, like almost all risk practitioners,
that there is no substitute for good human judgment and experience when making credit
decisions. Total reliance on models is neither feasible nor desirable. But failure to use the best
possible tools at hand is to fall further and further behind the best-practice techniques of the
industry, with a resulting decline in risk-adjusted profitability and, inevitably, an increase in
insolvency probability. We must remember that any improvement in the accuracy with which
risk is measured is tantamount to a reduction in risk. Continual improvements in risk
measurement techniques, therefore, should be the norm for all banks that intend to play in the
global financial marketplace. Institutions, and entire banking systems, that do not adhere to this
principle are doomed to repeat the blunders of the past.
In this new world of financial complexity and globalization, it is extremely
important that the large institutions among the developed nations all strive to keep up with the
best-practice frontier. These institutions are the ones that are the price-leaders, the drivers of
markets locally and internationally. If a group of important institutions in only one or two
countries fails to keep pace with risk measurement practices, all banking systems are placed at
risk. This risk, moreover, is not simply that a large bank failure in one country can cause
counterparty failures in other countries. Systematic under-pricing of credit and other risks can be
damaging to all players, not only to the bank making the pricing errors.
Fortunately, the free-market mechanism for the dissemination of best-practices
appears to be functioning reasonably smoothly, at least in the global sense. No single developed
nation appears to have a monopoly on best-practice risk measurement techniques, if innovations
in complex financial products are any indication. For example, European banks were market
leaders in introducing CLOs, or collateralized loan obligations. In the field of asset-backed
commercial paper facilities, US banks were the initiators, but now European and Japanese
institutions are significant players. And the ubiquitous consulting firms around the world can be
relied upon to spread the word of worthwhile advances in risk techniques.
Still, the individual bank in each country must face the proper incentives to keep
up with the most cost-effective risk techniques. Lax supervisory practices -- or, worse,
government support of banks with poor risk practices -- do not provide these proper incentives.
Thus, each supervisory authority in each developed nation must be ever vigilant that the
disparity between the world's best-practice institutions and those large banks that are "inside"
the best-practice frontier does not grow wider. Indeed, an important function of supervisors is to
act as something of a clearinghouse for best practices. If the supervisor perceives a deficiency in
practice, it is his responsibility to engage the bank manager in a discussion as to whether the
shortcoming really exists and, if so, how to fix it.
I will conclude by reiterating the three points I made at the beginning. First, there
is a strong and dynamic thread running between regulation and market innovation. While the
Basle Accord of 1988 was entirely appropriate to its time and circumstances, it is now clearly in
danger of becoming outmoded by the pace of financial innovation. Conversely, the regulation
has contributed to some market innovations that appear to be driven, if not solely, at least
primarily by the need to engage in regulatory capital arbitrage.
Second, the reality of globalization must be accounted for in designing and
implementing our regulatory and supervisory systems. Especially among developed nations, we
cannot afford a growing disparity in the quality of risk practices at our important institutions, nor
a disparity in the quality of supervision of those institutions. As bankers like to say, the worst
competitor is an uninformed competitor -- and that goes doubly for the competitor's supervisor.
Third, given that financial markets are constantly evolving, this means that our
regulatory framework must also continually evolve. The international capital standard has not
changed in basic form for almost a decade -- it is still a ratio-based rule. While it may still be
adequate for the vast bulk of banking institutions, it clearly is inadequate for the world's most
complex banks. For these institutions, high capital ratios do not necessarily equate with low
insolvency probabilities. Thus, the ratio-based standard is inefficient in achieving the
supervisors' objective of limiting bank failure to acceptable levels. Worse, it may be fostering
other inefficiencies in the banking system, to the extent the capital standard encourages
regulatory arbitrage that entails significant transaction costs.
In the absence of any viable alternatives, it is my view that we should begin now
to plan for a models-based successor to the Accord. Inevitably, this will take a tremendous
effort, given the complexity of the subject and the differences across institutions and between
countries. Moreover, a models-based system of capital regulation would require a degree of
cooperation among supervisors, quite apart from having similar written rules, that is
unprecedented. But I believe the effort will be worth it.
Thank you for the opportunity to air these concerns and I am looking forward to
continuing the dialogue on this subject.