Mr McDonough discusses sound banking
systems: a new growth imperative
Speech by Mr William J McDonough, President of the Federal Reserve Bank of New York, before
The Monetary Authority of Singapore, Singapore, on 24 March 2000.
* * *
I am delighted to be with you today. It's a special pleasure to be among so many old friends and
colleagues.
It's also a great pleasure to be in Singapore under such happy and promising circumstances. Just two
years ago, financial and economic conditions throughout Asia were rather grim and the outlook was
uncertain. But since then, to the great credit of the people of Asia, significant progress has been
achieved. In Thailand, Indonesia, Malaysia and especially Korea, meaningful headway has been made
toward recapitalizing the banking systems, ridding banks' balance sheets of problem assets, and
improving supervisory and regulatory frameworks.
And that hard-earned progress on the banking front is already bearing fruit. The economic contraction
that devastated so many in the region has generally been halted and even, in some countries,
impressively reversed. Equity markets have rebounded impressively, and yields on government
securities have been cut by nearly two-thirds as foreign capital has begun to return. Without question,
this is truly a remarkable turnaround.
It must also be acknowledged that the economies of Asia are not out of the woods just yet. Important
and even difficult work still lies ahead. At this critical juncture in the Asian recovery process, I think it
is worth reviewing just how important a stable banking and financial system is to the health and
vitality of any market economy - and particularly emerging market economies - and the crucial role
that supervision plays in achieving and preserving financial stability. Indeed, effective supervision
represents a crucial cornerstone of financial stability, both locally and globally. It is also clear that,
given the accelerating pace of change and innovation in the financial services industry, our notion of
supervision must encompass discipline applied by the marketplace, as well as official supervision.
With these thoughts in mind, and noting the critical role banks play in a market economy, in my
remarks today I will discuss the nature and form of an effective supervisory framework for the
21st century, addressing the role to be played by banks themselves, the broader marketplace and
official supervisors. On the subject of official supervision, I will address the Basel Committee's Core
Principles for Effective Supervision, and then conclude with a discussion of the Committee's major
initiative to revise and refine the 1988 Capital Accord.
Banks' role in a market economy
Let me first discuss the crucial role banks play in a market economy. While specific arrangements may
vary from country to country reflecting differences in history, custom and culture, the basic principles
are common to nearly all market economies.
Bringing savers and borrowers together
As we all know, starting a business, expanding an existing business, or embarking on any other kind of
creative or entrepreneurial enterprise, requires money - investment capital. Therefore, any society's
long-term economic prospects are best served when households and businesses freely decide to save
part of their current income.
But the decision to save is not, in itself, sufficient to ensure economic growth and prosperity. Some
institutional mechanism must exist through which society's savings can be collected and channeled
into productive investments. Moreover, because savers will naturally perceive risk in parting with their
money, they must be induced to entrust their savings to that institution that can then put their capital to
work in sound and productive ways.
For this to happen, a class of financial institutions must exist that the public views as a safe and
convenient outlet for its savings, where at least some fraction of those savings are maintained in the
form of highly liquid assets, and assets by which payments for goods and services can be made
quickly, easily and safely.
The single dominant class of institution that has emerged to play this crucial role of intermediating
between savers and borrowers is the commercial bank. In virtually all countries, banks function as the
repository of a large fraction of society's liquid savings and the entities through which payments are
made. Even in mature industrial societies with highly developed capital markets, the commercial
banking system continues to be the most important single element of the financial system.
Transaction accounts - the means of intermediation
The prominent position of banks in the financial systems of market economies around the world stems
from their unique role as the issuers of transaction accounts. Transaction accounts are bank liabilities
that are immediately payable on demand at face value - "at par" - and that are readily transferable to
third parties. Because a depositor may transfer or convert into currency the balance of a transaction
account on demand, such accounts are often referred to as "demand deposits". Owners of transaction
accounts can withdraw deposited funds, write checks up to the full amount in the account, or transfer a
portion or the full amount of the account to a third party. The liquidity, acceptability and
transferability of these accounts induce savers to entrust their savings to banks, and facilitate the broad
range of transactions that sustain economic activity.
The unique capacity to incur liabilities that are payable on demand at par distinguishes banks from all
other kinds of institutions, and is the determining characteristic that enables banks to perform their
essential functions in a market-based economy. Banks are also the only type of institution that can
create transaction accounts by way of the lending function, and thereby expand the money supply by
way of the money multiplier. The flexibility of credit and liquidity that banks provide - stemming from
this unique capacity to create transaction account liabilities - is vital to the smooth development and
growth of market-based economies.
Other essential functions
This money-creating capacity also enables banks to perform other essential functions. For example,
banks serve as the primary and back-up source of liquidity for other classes of institutions, financial
and non-financial. Even in advanced financial systems, the capital markets rely heavily on the banking
system to meet day-to-day cash flow needs and to provide standby financing facilities. In addition, the
banking system is the mechanism, or transmission belt, by which the policies of the central bank
regarding money and credit creation are implemented, and the pace of economic activity determined.
Simply stated, without an effectively functioning banking system for encouraging, collecting and
deploying society's savings, providing the means for quick and reliable payment, and performing
these other essential functions I've just mentioned, there would be little hope for any economy to
mobilize the real resources necessary for economic growth and stability. If money and credit are the
lifeblood of a market economy - and they are - the banking system is its beating heart.
Public confidence - the key to intermediation
But banks' ability to collect and mobilize society's savings by attracting deposits is only half of the
story. Their ability to retain those deposits is just as critical. This may seem an obvious point, but the
retention side of the banking equation is too often forgotten or overlooked.
The willingness of savers to entrust their money to a bank presupposes that those savers have
confidence in the financial integrity of the institution - in other words, that their savings will be
available when they need or want access to them. If that confidence is undermined, society's ability to
collect and deploy its savings will be impaired, and the principal means to economic growth and rising
living standards - intermediation by banks - will be short-circuited. With this reality in mind, it must
be acknowledged that, in the final analysis, commercial banks have only one asset that really matters
public confidence.
Sound lending - the key to preserving public confidence
The key to maintaining the financial integrity of any banking company - and, therefore, to preserving
the all-important asset of public confidence - is the credit process. If credit is extended carelessly,
banks are likely to incur losses, which in turn will undermine their ability to honor deposit obligations.
And if banks' ability to honor deposit obligations falls into question, if the public's confidence is
undermined, households and businesses will likely rush to redeploy their savings, raising the specter of
a flight to cash and real assets with all the associated implications for inflation and destabilizing runs
on banks. The best defense against this serious and very real threat is for banks to extend credit wisely,
objectively and impartially.
In this connection, it should be emphasized that, because of the inherently partisan nature of politics,
and for other reasons as well, the government or state is not well-equipped to make credit decisions.
Recent experience here in Asia, and before that in the former command economies of Eastern Europe,
makes clear just how dangerous "policy lending" can be. Decisions as to who gets credit and who does
not must be left to private initiative within a context where those making the decisions have a major
stake - their own capital and economic livelihood. If the system is working properly, those receiving
credit will be the most efficient, competitive, and profitable - those most capable of producing the
stream of goods and services that will enable the economy to grow and, as a result, for living standards
to rise.
The purpose of supervision - preserving financial stability
This, then, is the fundamental tension of commercial banking - how to meet the credit needs of a
healthy and expanding market economy, which necessarily entails the taking of calculated risks, and
yet preserve the confidence of depositors whose savings are the raw material that enable banks to
perform their essential functions. Negotiating that tension, helping banks meet that challenge, is the
critical task of supervision.
And so what is the purpose of supervision in the 21st century? What are the objectives? How can those
objectives be best pursued? Let me say first of all that there is no quick-fix or single answer. The
21st century financial marketplace is too dynamic, too complex, and supervisors must work within the
political realities of our respective nations. Instead, what I envision is a flexible, multi-faceted strategy
that emphasizes prudence and prevention, compatibility with the market, and that fosters a close and
cooperative partnership 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. The purpose of the board of directors is to oversee the development
of the overall strategy of the organization and the decisions made by senior management in pursuit of
those strategic objectives. The role of senior management, in turn, is to oversee day-to-day decisions
made within the organization and to 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;
• 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 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. 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. As I mentioned earlier, 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 the institutional management culture required to ensure that written
policies and procedures are actually translated into practice, with buy-in at all staff levels. And
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 their 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 - constitute a kind of internal safety net and
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. As financial institutions and their activities become more complex, diversified and
global, market discipline becomes an even more important ally of the official supervisor.
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 need to 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. I strongly
users
encourage all financial market participants to approach the issue of disclosure as of financial
statements rather than as issuers. What we all need to know about each other to be comfortable and
secure in making our credit decisions should drive the debate, rather than concerns about proprietary
information.
There is 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 a stable financial marketplace than a loss of confidence - and nothing undermines
confidence more than a lack of reliable information. Discipline imposed by markets might not always
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.
Here in Asia, as in other markets, more work needs to be done to improve the quality of disclosures
regarding traditional banking activities. Time and again experience has shown that in periods of stress,
insufficient or inaccurate information about asset quality can lead to rumors and overreactions in the
marketplace, creating the potential for problems to spread to institutions that may otherwise be in good
health.
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 make rigorous decisions as to which enterprises meet market
tests of efficiency, competitiveness, and profitability that are necessary for those enterprises 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'll have more to say about market discipline and its role in the evolving framework of
regulatory capital in a few moments.
Role of supervisors
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 system, and in the financial system
more generally, can be summed up as promoting financial stability and minimizing systemic risk. This
is a broad mandate - one that encompasses the responsibility to ensure that markets operate in a fair,
transparent and efficient manner, and that participants comply with the rules of the game.
Indeed, supervisors bring a number of comparative advantages to the table that enable them to play
this critical role in the broader supervisory framework. First, supervisors have clear incentives to
monitor risks to the financial system as a whole. While each financial institution is best positioned to
monitor its own risk exposure, it does not have the incentives to internalize the costs it may impose on
other financial institutions should it experience difficulties.
Second, supervisors are able to obtain and monitor proprietary information about an institution's risk
exposures, its management information systems and its internal controls when such information is not
publicly disclosed.
Third, supervisors are in a unique position to observe trends across groups of financial institutions and,
based on these insights, to provide the industry with a perspective on what constitutes best practice.
Fourth, official supervision is needed to enforce compliance with applicable laws and regulations. We
have observed that poor compliance, beyond simply being wrong, can result in serious operational
problems, including capital allocation deficiencies, managerial oversights and increased reputational
risk. As we have seen, such problems can threaten the wellbeing of a financial institution and carry the
potential for systemic risk.
Finally, supervisors are able to assure that prompt corrective actions are taken when serious financial
or other problems are identified, particularly if the problems are not known to the market. The
importance of the role supervisors can play in problem cases, both through public enforcement and
through other less visible means, cannot be overstated.
Changes in the financial services industry present new challenges for how official supervision is to be
carried out most effectively. 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, we as supervisors should continue our 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 the institution and its
capital are exposed, given its array of business activities. By "process-oriented", I mean that examiners
and auditors should ascertain 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.
As I alluded to earlier, specific supervisory arrangements, practices and techniques vary from country
to country depending on differences in culture, financial system structure and internal political
realities. Having said that, a set of basic principles can be identified that should guide all supervisors
in an increasingly interconnected, global financial marketplace. In 1997, the Basel Committee on
Banking Supervision issued a set of twenty-five Core Principles for Effective Banking Supervision
intended to serve as a benchmark against which the effectiveness of particular supervisory regimes can
be assessed. If you're not familiar with the Principles, I'm pleased to bring them to your attention
today.
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 each 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. Some might argue that such extensive consultation slows
down the process and dilutes the final product. I strongly disagree. Only through this inclusive
approach could we design comprehensive principles with broad applicability and support.
Last October, 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
including many here in Asia - 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 training of supervisors in emerging market countries and facilitates technical assistance.
This May, the Basel Committee plans to bring together supervisors from emerging market countries
and representatives from the IMF and World Bank to discuss the lessons learned from this initiative.
The May meeting is part of the Committee's ongoing commitment to ensure that the Core Principles
remain current and relevant to bank supervisors worldwide.
Let me move on to the Basel Committee's initiative to revise the 1988 Accord. As you know, capital
has played, and continues to play, an important role in the supervisory tool kit. Adequate capital helps
ensure that shareholders monitor the risk of financial institutions, and that management puts in place
and maintains appropriate oversight mechanisms to help prevent problems from surfacing in the first
place. Should an institution experience difficulties, capital serves as a buffer to absorb losses and
reduce the risk of spillover from a problem institution to other financial institutions.
The primary tool of capital regulation currently is the set of minimum ratios that were devised in 1988
by the Basel Committee on Banking Supervision. They were set forth in an agreement known as the
Basel Accord, and were adopted, among other reasons, to address the slide in international capital
levels that was occurring over the previous decade. The Accord was clearly a milestone achievement
for the first time, supervisors in G10 countries were able to use a common yardstick for assessing
banks' capital adequacy.
But the Accord has a number of serious shortcomings. For example, it does not adequately
differentiate among degrees of credit risk and, as a result, banks have had incentives to take on higher
risk exposures within broad risk categories. Banks have also tended to engage in transactions that
lower capital requirements without reducing economic risk.
In addition, it has proved difficult to incorporate into the Accord's simple risk-weighting scheme the
innovations of the last decade in the way banks manage and mitigate risk. As market risk management
techniques developed, we were able to incorporate a state-of-the-art, value-at-risk approach in a 1996
Market Risk Amendment. Still, as credit risk management techniques have advanced, and as the
importance of operational risk management has increasingly been recognized, it has become apparent
that the long run relevance and efficacy of the Basel ratios as an indicator of capital adequacy has been
eroded.
Supervisors have long known that analyzing simple capital ratios in isolation can lead to incorrect
conclusions about the relative strengths of institutions. Thus, we also have relied on a review of banks'
capital plans and on market discipline to assess capital adequacy. In June of last year, the Basel
Committee formalized the link between these elements when it released a Consultative Paper laying
out our vision for a new, more refined capital adequacy framework.
In addition to establishing minimum capital requirements, the proposed framework places increased
emphasis on the supervisory review of capital adequacy and the role of market discipline. We refer to
these elements - minimum standards, supervisory review and market discipline - as the "three pillars".
Together these pillars mutually reinforce safety and soundness by aligning capital relative to risk and
by encouraging prudent risk management. This evolution in the Committee's thinking about capital
adequacy follows from much of our recent work on risk management and the surveys we have
conducted on banks' disclosure practices. It is also consistent with the broader notion of supervision
I've discussed today.
We encourage comments on the Committee's proposals from both supervisors and industry
participants through 31 March 2000 - which is next week - and plan to publish, hopefully early next
year, a comprehensive set of proposals that will be responsive to the comments and input we have
received.
Let me highlight briefly each of the three pillars and provide some perspective on the key challenges
that the Committee faces in relation to each. The first pillar is minimum capital requirements. To
address the shortcomings in the 1988 Accord, the Basel Committee has proposed two primary
approaches:
• an enhanced standardized approach that ties risk weightings to external credit assessments
such as credit ratings; and
• an internal ratings-based approach that would begin by mapping internal risk ratings into
standardized risk weightings, but might eventually evolve into something closer to the full
use of credit risk models.
Each approach treats the trade-off between simplicity and accuracy somewhat differently and thus one
or the other is likely to be relevant to banks with different levels of sophistication. Most importantly,
both proposed approaches attempt to introduce greater risk sensitivity into the minimum capital
standards to address the unfortunate incentive problems that have evolved from the 1988 Accord.
Some observers - including, perhaps, a few in this room - have noted that the effort to incorporate
greater risk-sensitivity into the framework inevitably introduces procyclicality into our standards. That
is, the capital requirements for loans to troubled borrowers will tend to increase at just the point when
such trouble is becoming apparent. This is an important point, and one that we at the Committee are
working to address. It is my view th