Ms. Rivlin discusses the prudential regulation of banks and how to improve
it Remarks by the Vice Chairman of the Board of Governors of the US Federal Reserve
System, Ms. Alice M. Rivlin, at the The Brookings Institution National Issues Forum in
Washington on 19/12/96.
I discovered when I joined the Board of Governors of the Federal Reserve System
about six months ago that most of my friends -- including my sophisticated public policy
oriented friends -- had only a hazy notion what their central bank did. Many of them said,
enthusiastically, "Congratulations!" Then they asked with a bit of embarrassment, "Is it a
full-time job?" or "What will you find to do between meetings?" The meetings they were aware
of, of course, were those of the Federal Open Market Committee. They knew that the FOMC
meets every six weeks or so to "set interest rates." That sounds like real power, so the FOMC
gets a lot of press attention even when, as happened again this week, we meet and decide to do
absolutely nothing at all.
The group gathered here today, however, realizes that monetary policy, while
important, is not actually very time-consuming. If you cared enough to come to this conference,
you also have a strong conviction that the health and vigor of the American economy depends
not only on good macro-economic policy, although that certainly helps, but also on the safety,
soundness and efficiency of the banking system. We need a banking system that works well and
one in which citizens and businesses, foreign and domestic, have high and well placed
confidence.
So I want to talk today, as seems appropriate on the fifth anniversary of FDICIA,
about the subject that occupies much of our attention at the Federal Reserve: the prudential
regulation of banks and how to improve it. Indeed, I want to focus today, not so much on what
Congress needs to do to ensure the safety and soundness of the bank system in this rapidly
changing world -- there are others on the program to take on that task -- but more narrowly on
how bank regulators should go about their jobs of supervising bank risk-taking.
The evolving search for policies that would guarantee a safe, sound and efficient
banking system has featured learning from experience. In the 1930s, Americans learned,
expensively, about the hazards of not having a safety net in a crisis that almost wiped out the
banking system. In the 1980s, they learned a lot about the hazards of having a safety net,
especially about the moral hazard associated with deposit insurance.
Deposit insurance, which had seemed so benign and so successful in building
confidence and preventing runs on banks, suddenly revealed its downside for all to see. Some
insured institutions, mostly thrifts, but also savings banks, and not a few commercial banks,
were taking on risks with a "heads I win, tails you lose" attitude -- sometimes collecting on high
stakes bets but often leaving deposit insurance funds to pick up the pieces. At the same time,
some regulators, especially the old FSLIC, which was notably strapped for funds, were
compounding the problem -- and greatly increasing the ultimate cost of its resolution -- by
engaging in regulatory "forbearance" when faced with technically insolvent institutions.
The lessons were costly, but Americans do learn from their mistakes. The
advocates of banking reform, many of them participants in this conference, saw the problems
posed by moral hazard in the context of ineffectual supervision and set out to design a better
system.
Essentially, the reform agenda had two main components:
* First, expanded powers for depository institutions that would permit them to
diversify in ways that might reduce risks and improve operating efficiency;
* Second, improving the effectiveness of regulation and supervision by
instructing regulators, in effect, to act more like the market itself when
conducting prudential regulation.
FDICIA was a first step toward meeting the second challenge -- how to make
regulators act more like the market. It called for a reduction in the potential for regulatory
"forbearance" by laying down the conditions under which conservatorship and receivership
should be initiated. It called for supervisory sanctions based on measurable performance (in
particular, the Prompt Corrective Action provisions that based supervisory action on a bank's
risk-based capital ratio). The Act required the FDIC and RTC to resolve failed institutions on a
least-cost basis. In other words, the Act required the depository receivers to act as if the
insurance funds were private insurers, rather than continue the past policy of protecting
uninsured depositors and other bank creditors. Finally, FDICIA placed limitations on the
doctrine of "Too Big To Fail," by requiring agency consensus and administration concurrence in
order to prop up any large, failing bank. In a few places, however, FDICIA went too far. The
provisions of the Act that dealt with micro management by regulators were immediately seen to
be "over the top," and were later repealed. The Act provided a framework for regulators to
invoke market-like discipline. It left room for them to move their own regulatory techniques in
this direction -- a subject to which I will return in a minute.
The other objective of reform -- diversification of bank activities through an
expansion of bank powers -- has not yet resulted in legislation and is still very much an on-going
debate. In part, this failure to take legislative action reflected the long-running ability of the
nonbank competition to use its political muscle to forestall increased powers for banks. But the
inaction on expanded powers also reflected a Congressional concern that additional powers
might be used to take on additional risk, which, on the heels of the banking collapse of the late
1980s, represented poor timing, to say the least. There was also some Congressional disposition
to punish "greedy bankers," who were seen as the reason for the collapse and the diversion of
taxpayer funds to pay for thrift insolvencies. Whatever the reasons, not only did the 102nd
Congress fail to enact expanded bank powers, but so did the next two Congresses. We are
hopeful that the 105th Congress will succeed where its predecessors have failed. Meanwhile, the
regulatory agencies have acted to expand bank powers within the limits of existing law.
The Federal Reserve has proposed both liberalization of Section 20 activities and
expedited procedures for processing applications under Regulation Y. The OCC has acted to
liberalize banks' insurance agency powers and, most recently, to liberalize procedures for
operating subsidiaries of national banks. Of course, I would have to turn in my Federal Reserve
badge and give up my parking pass if I did not mention that we at the Fed believe that some
activities are best carried out in a subsidiary of the holding company rather than a subsidiary of
the bank. We believe that the more distance between the bank and its new, nonbank operations,
the more likely that we can separate one from the other and avoid the spreading of the subsidy
associated with the safety net.
While the regulators can move in the right direction, it is still imperative that
Congress act. Artificial barriers between and among various forms of financial activity are
harmful to the best interests of the consumers of financial services, to the providers of those
services, and to the general stability and well-being of our financial system, most broadly
defined. Congress should consider this issue and take the next steps.
Let me turn now to what I consider to be one of the most critical issues facing
regulators, especially in a future in which financial markets likely will dictate significant further
increases in the scope and complexity of banking activities. I am referring to the issue of how to
conduct optimal supervision of banks. Fortunately, there appears actually to be an evolving
consensus at least on the general principle. Regulators, including the Federal Reserve, strongly
support the basic approach embodied in FDICIA; namely that regulators should place limits on
depository institutions in such a way as to replicate, as closely as possible, the discipline that
would be imposed by a marketplace consisting of informed participants and devoid of the moral
hazard associated with the safety net.
Unfortunately, as always, the devil is in the details. The difficult question is how
should a regulator use "market-based" or "performance-based" measures in determining which,
if any, supervisory sanctions or limits to place on a bank. FDICIA's approach was
straightforward. Supervisory sanctions under Prompt Corrective Action were to be based on the
bank's risk performance as measured by its levels of regulatory capital, in particular its leverage
ratio and total risk-based capital ratio under the Basle capital standards. These standards now
seem well-intended but rather outdated. Certainly, the Basle capital standards did the job for
which they were designed, namely stopping the secular decline in bank capital levels that, by the
late 1980s, threatened general safety and soundness. But the scope and complexity of banking
activities has proceeded apace during the last two decades or so, and standard capital measures,
at least for our very largest and most complex organizations, are no longer adequate measures on
which to base supervisory action for several reasons:
* The regulatory capital standards apportion capital only for credit risk and, most
recently, for market risk of trading activities. Interest rate risk is dealt with
subjectively, and other forms of risk, including operating risk, are not treated
within the standards.
* Also, the capital standards are, despite the appellation "risk-based," very much
a "one-size-fits-all" rule. For example, all non-mortgage loans to corporations
and households receive the same arbitrary 8 percent capital requirement. A
secured loan to a triple-A rated company receives the same treatment as an
unsecured loan to a junk-rated company. In other words, the capital standards
don't measure credit risk although they represent a crude proxy for such risk
within broad categories of banking assets.
* Finally, the capital standards give insufficient consideration to hedging or
mitigating risk through the use of credit derivatives or effective portfolio
diversification.
These shortcomings of the regulatory capital standards were beginning to be
understood even as they were being implemented, but no consistent, consensus technology
existed at that time for invoking a more sophisticated standard than the Basle norms. To be sure,
more sophisticated standards were being used by bank supervisors, during the examination
process, to determine the adequacy of capital at any individual institution. These supervisory
determinations of capital adequacy on a bank-by-bank basis, reflected in the CAMEL ratings
given to banks and the BOPEC ratings given to bank holding companies, are much more
inclusive than the Basle standards. Research shows that CAMEL ratings are much better
predictors of bank insolvency than "risk-based" capital ratios. But, a bank-by-bank supervision,
of course, is not the same thing as the writing of regulations that apply to all banks.
It is now evident that the simple regulatory capital standards that apply to all
banks can be quite misleading. Nominally high regulatory capital ratios -- even risk-based
capital ratios that are 50 or 100 percent higher than the minimums -- are no longer indicators of
bank soundness.
Meanwhile, however, some of our largest and most sophisticated banks have been
getting ahead of the regulators and doing the two things one must do in order to properly
manage risk and determine capital adequacy. First, they are statistically quantifying risk by
estimating the shape of loss probability distributions associated with their risk positions. These
quantitative measures of risk are calculated by asset type, by product line, and, in some cases,
even down to the individual customer level. Second, the more sophisticated banks are
calculating economic capital, or "risk capital," to be allocated to each asset, each line of
business, and even to each customer, in order to determine risk-adjusted profitability of each
type of bank activity. In making these risk capital allocations, banks are defining and meeting
internal corporate standards for safety and soundness. For example, a banker might desire to
achieve at least a single-A rating on his own corporate debt. He sees that, over history, single-A
debt has a default probability of less than one-tenth of one percent over a one year time horizon.
So the banker sets an internal corporate goal to allocate enough capital so that the probability of
losses exceeding capital is less than 0.1 percent. In the language of statistics, this means that
allocated capital must "cover" 99.9 percent of the estimated loss probability distribution.
Once the banker estimates risk and allocates capital to that risk, the internal
capital allocations can be used in a variety of ways -- for example, in so-called RAROC or
risk-adjusted return on capital models that measure the relative profitability of bank activities. If
a particular bank product generates a return to allocated capital that is too low, the bank can seek
to cut expenses, reprice the product, or focus its efforts on other, more profitable ventures. These
profitability analyses, moreover, are conducted on an "apples-to-apples" basis, since the
profitability of each business line is adjusted to reflect the riskiness of the business line.
What these bankers have actually done themselves, in calculating these internal
capital requirements, is something regulators have never done -- defined a bank soundness
target. What regulator, for example, has said that he wants capital to be high enough to reduce to
0.1 percent the probability of insolvency? Regulators have said only that capital ratios should be
no lower than some number (8 percent in the case of the Basle standards). But as we should all
be aware, a high capital ratio, if it is accompanied by a highly risky portfolio composition, can
result in a bank with a high probability of insolvency. The question should not be how high is
the bank's capital ratio, but how low is its failure probability.
In sharp contrast to our 8 percent one-size-fits-all capital standard, the internal
risk-capital calculations of banks result in a very wide range of capital allocations, even within a
particular category of credit instrument. For example, for an unsecured commercial credit line,
typical internal capital allocations might range from less than 1 percent for a triple-A or
double-A rated obligor, to well over 20 percent for an obligor in one of the lowest rating
categories. The range of internal capital allocations widens even more when we look at capital
calculations for complex risk positions such as various forms of credit derivatives. This great
diversity in economic capital allocations, as compared to regulatory capital allocations, creates at
least two types of problem.
* When the regulatory capital requirement is higher than the economic capital
allocation, the bank must either engage in costly regulatory arbitrage to evade
the regulatory requirement or change its portfolio, possibly leading to
suboptimal resource allocation.
* When the regulatory requirement is lower than the economic capital
requirement, the bank may choose to hold capital above the regulatory
requirement but below the economic requirement; in this case, the bank's
nominally high capital ratio may mask the true nature of its risk position.
Measuring bank soundness and overall bank performance is becoming more
critical as the risk activities of banks become more complex. This condition is especially evident
in the various nontraditional activities of banks. In fact, "nontraditional" is no longer a very
good adjective to describe much of what goes on at our larger institutions. Take asset
securitization, for example. No longer do our largest banks simply take in deposit funds and lend
out the money to borrowers. Currently, well over $200 billion in assets that, in times past, have
resided on the books of banks, now are owned by remote securitization conduits sponsored by
banks. Sponsorship of securitization, which is now almost solely a large bank phenomenon,
holds the potential for completely transforming the traditional paradigm of "banking." Now,
loans are made directly by the conduits, or are made by the banks and then immediately sold to
the conduits. To finance the origination or purchase of the loans, a conduit issues several classes
of asset-backed securities collateralized by the loans. Most of the conduit's debt is issued to
investors who require that the senior securities be highly rated, generally double-A and triple-A.
In order to achieve these ratings, the conduit obtains credit enhancements insulating the senior
security holders from defaults on the underlying loans. Generally, it is the bank sponsor that
provides these credit enhancements, which can be in the form of standby letters of credit to the
conduit, or via the purchase of the most junior/subordinated securities issued by the conduit. In
return for providing the credit protection, as well as the loan origination and servicing functions,
the bank lays claim to all residual spreads between the yields on the loans and the interest and
non-interest cost of the conduit's securities, net of any loan losses. In other words, securitization
results in banks taking on almost identically the same risks as if the loans were kept on the books
of the bank the old-fashioned way.
But while the credit risk of a securitized loan pool may be the same as the credit
risk of holding that loan pool on the books, our capital standards do not always recognize this
fact. For example, by supplying a standby letter of credit covering so-called "first-dollar" losses
for the conduit, a bank might be able to reduce its regulatory capital requirement, for some of its
activities, by 90 percent or more compared with what would be required if the bank held the
loans directly on its own books. The question, of course, is whether the bank's internal capital
allocation systems recognize the similarity in risk between, on the one hand, owning the whole
loans and, on the other hand, providing a credit enhancement to a securitization conduit.
If the risk measurement and management systems of the bank are faulty, then
holding a nominally high capital ratio -- say, 10 percent -- is little consolation. In fact, nominally
high capital ratios can be deceiving to market participants. If, for example, the bank's balance
sheet is less than transparent, potential investors or creditors, seeing the nominally high
10 percent capital, but not recognizing that the economic risk capital allocation should, in
percentage terms, be much higher, could direct an inappropriately high level of scarce resources
toward the bank.
Credit derivatives are another example of the evolution. The bottom line is that,
as we move into the 21st century, traditional notions of "capital adequacy" will become less
useful in determining the safety and soundness of our largest, most sophisticated, banking
organizations. This growing discrepancy is important because "performance-based" solutions
likely will continue to be touted as the basis for expanded bank powers or reductions in
burdensome regulation. For example, the Federal Reserve's recent proposed liberalization of
procedures for Regulation Y activities applies to banking companies that are "well-capitalized"
and "well-managed." Similarly, the OCC's recent proposed liberalization of rules for bank
operating subsidiaries applies to "well-capitalized" institutions. Also, industry participants
continue to call for expanded powers and/or reduced regulatory burden based on "market tests"
of good management and adequate capital.
It will not be easy reaching consensus on how to measure bank soundness and
overall bank performance. It cannot simply be done by observing market indicators. For
example, we cannot easily use the public ratings of holding company debt. The ratings, after all,
are achieved given the existence of the safety net. The ratings are biased, therefore, from the
perspective of achieving our stated goal -- to impose prudential limits on banks as if there were
no net. In addition, I am sure that there would be disagreement between market participants and
regulators over what should be acceptable debt ratings. The solution may be for the regulators to
use the analytical tools developed by the market participants themselves for risk and
performance assessment. Regulators already have begun to move in this direction. For example,
beginning in January 1998, qualifying large multinational banks will be able to use their internal
Value-at-Risk models to help set capital requirements for the market risk inherent in their
trading activities. The Federal Reserve is also conducting a pilot test of the pre-commitment
approach to capital for market risk. In this approach, banks can choose their own capital
allocations, but would be sanctioned heavily if cumulative trading losses during a quarter were
to exceed their chosen capital allocations. These new and innovative methods for treating the
age-old problem of capital adequacy are likely to be followed by an unending, evolutionary flow
of improvements in the prudential supervisory process. As the industry makes technological
advances in risk measurement, these advances will become imbedded in the supervisory process.
For example, the banking agencies have announced programs to place an increased emphasis on
banks' internal risk measurement and management processes within the assessment of overall
management quality -- that is, how well a bank employs modern technology to manage risk will
be reflected in the "M" portion of the bank's CAMEL rating. In a similar vein, now that VaR
models are being used to assess regulatory capital for market risk, it is easy to envision that,
down the road, banks' internal credit risk models and associated internal capital allocations will
also be used to help set regulatory capital requirements.
Regulation and supervision, like industry practices themselves, are continually
evolving processes. As supervisors, our goal must be to stay abreast of best practices,
incorporate these practices into our own procedures where appropriate, and do so in a way that
allows banks to remain sufficiently flexible and competitive. In conducting prudential regulation
we should always remember that the optimal number of bank failures is not zero. Indeed,
"market-based" performance means that some institutions, either through poor management
choices, or just because of plain old bad luck, will fail. As regulators, we must carefully balance
these market-like results with concerns over systemic risk. And, as regulators of banks, we must
always remember that we do not operate in a vacuum -- the activities of nonbank financial
institutions are also important to the general well-being of our financial system and the macro
economy.
Regulators, of course, can only work with the framework laid down by Congress.
Let me conclude with the hope that this Congress will build on the experience of the last few
years, including the experience with FDICIA, and take the next steps toward creating a structural
and regulatory framework appropriate to the 21st century.