Ms. Phillips discusses the changing financial landscape and umbrella
supervision in the United States Remarks by Governor Susan M. Phillips, a member of the
Board of Governors of the US Federal Reserve System, at the Exchequer Club in Washington on
18/6/97.
It is a pleasure to be here today at the Exchequer Club. I thank you for the
opportunity to discuss the changing financial landscape and offer my own perspectives on what
the future might bring. During the next few months, there will be significant debates on various
aspects of financial modernization, both within and without the halls of Congress. These debates
may well set the stage for how financial service companies will operate as we enter the
twentyfirst century.
As we can all plainly see, the world is changing across many dimensions, posing
new and ever-increasing challenges for both financial services firms and their supervisors. To
succeed in this new world, I believe it is important for the industry and supervisors to find
common ground for coping with these challenges. By working together to find solutions, we can
both accomplish our goals, while retaining the core principles and values that have contributed
to the industry's success.
So today I would like to discuss briefly the changes underway affecting the
financial services industry, as well as the individual and collective responses by the industry and
supervisors to those changes. Then lastly, I will offer some thoughts on what the role of an
umbrella supervisor might look like in this changing environment for financial services. All of
these changes must be considered in the context of possible legislative reform.
The Changing World
As widely noted, dramatic advances in information and telecommunication
technologies have allowed banks to develop new and more customized products and services and
deliver them over a broader geographic area with greater efficiency. Such innovations by the
banking industry, and by financial markets in general, have increased the sophistication and
complexity of bank lending, investing, trading, and funding. They have propelled growth in less
traditional or newer banking activities such as investment banking, mutual fund management,
insurance and securitization. In the process, the risk profiles of many banking organizations have
been altered in fundamental ways, placing greater pressure on management to monitor and
manage underlying risks.
To meet this challenge, a growing number of institutions are employing modern
financial theory for measuring and analyzing the trade-off between risk and returns. The
availability of dramatically more powerful computers at ever more affordable prices has allowed
institutions to process vast data bases of rates, prices, defaults, and recoveries. As a result,
techniques for portfolio management and risk measurement that not long ago were possible only
in theory are now becoming integral parts of daily operating practice. By applying these theories
and techniques, institutions today are more effectively pricing and hedging risk, allocating
capital, evaluating risk-adjusted returns and identifying the optimum mix of financial products
or services. I believe these enhanced management practices have contributed importantly to the
economic growth and market gains seen in recent years.
As competition has intensified, we have seen a growing overlap in the activities
and product lines provided by both banks and other financial service providers that has
diminished the past distinction between banks and many nonbank firms. That trend has raised
public policy questions regarding bank powers and the appropriate organizational structure
through which banking organizations should gain new powers. Proposals recently introduced in
Congress to address those issues would fundamentally redefine the relationship of banks to other
financial services companies and in some instances their relationship to commercial firms as
well.
Banks have not only expanded their products and activities, but have also
expanded their geographic reach, both domestically and globally. Within the United States,
banks have expanded nationwide as barriers to interstate banking have been removed. This
expansion should continue as banks exercise their new power to branch across state lines. A
related domestic trend is the rapid consolidation within and between banking organizations.
Although some consolidation is undoubtedly related to the removal of barriers to interstate
branching, it is also spurred by improved technology, strong competition in banking markets,
and the drive by banks to reduce costs.
Internationally, the globalization of banking has accelerated, driven by improved
technology and the opening of economies in eastern Europe, Asia, Latin America, and other
regions. In particular, U.S. and other international financial institutions are forging a growing
presence in lending, trading, and underwriting in these emerging markets. These efforts have
created closer links among the world's financial markets and have improved the efficiency and
availability of capital. However, market integration has also increased the potential for systemic
problems to transcend national borders, as the volume of international financial transactions has
grown. Last year, for example, an estimated $1.5 trillion of foreign exchange contracts were
settled daily in New York City alone. A default by a major U.S. or foreign participant in that
market could disrupt financial markets worldwide.
Competitive pressures are intense to reduce the cost of financial services to the
public. This is occurring against the need to improve the financial strength and competitiveness
of the banking industry from the levels at the beginning of this decade. These factors have, in
turn, also placed pressure on the banking agencies to remove unnecessary burdens on the
industry without threatening safety and soundness.
Regulatory and Supervisory Responses to Change
What have been the regulatory and supervisory responses to these changes? Let
me first discuss how we addressed the issue of regulatory burden. Although the poor bank
profitability of the 1980s and early 1990s was mostly related to industry asset quality problems,
regulators and Congress alike recognized that improvements could be made in bank regulations
and in supervisory processes to improve credit availability and bank competitiveness without
sacrificing safety and soundness.
Both legislative and regulatory efforts undertaken in the decade of the 1990's
have simplified regulatory reporting requirements, expedited the application process, eliminated
duplicate regulatory filings, and have led to more streamlined and uniform banking agency
guidelines and regulations. Taken individually, these and other refinements may not appear
material, but taken as a whole they have put a meaningful dent in regulatory costs. In fact, the
industry on several occasions has reminded us that it is not necessarily any particular individual
regulatory requirement that is problematic, but rather, their cumulative effect, much like the
straw that broke the camel's back. We have taken that point to heart when considering new
guidelines and regulations.
Efforts to reduce regulatory burden apply not only to banks, but to holding
companies as well. Earlier this year, for example, the Board streamlined Regulation Y and
reduced application requirements. These changes recognize that regulatory burden arises not
only from the direct operational costs of compliance, but also from the indirect costs of delayed
or lost opportunities to enter new activities.
To reduce impediments, the Board has decided that the application process should
focus on the analysis of the effects of a specific proposal, and should not generally become a
vehicle for comprehensively evaluating and addressing supervisory and compliance issues.
Rather, the latter can more effectively be addressed in the supervisory process. The Board also
recently completed a lengthy review of its policies and procedures for assessing the competitive
implications of bank mergers and acquisitions. Modifications have been made to that process to
make it more efficient and address the potential benefits of scale economies for small bank
mergers.
Another improvement in our regulations is the ability of well-capitalized,
wellrun companies to apply to acquire banks and nonbanks in a faster more streamlined fashion and
to commence nonbanking activities approved by regulation without obtaining prior approval. To
allow bank holding companies greater opportunities to innovate, the Board has also indicated
that it will be pro-active in approving new activities.
Further efforts to provide flexibility and help modernize bank holding company
regulations have been directed toward securities firms known as section 20 affiliates. Last year
the Board raised the Section 20 ineligible revenue limit on underwriting and dealing in securities
from 10 to 25 percent. This appears to be allowing greater flexibility for these operations.
The Board has also eliminated certain firewalls between banks and their securities
affiliates and for other firewalls has proposed to eliminate or scale back even more, recognizing
that other laws, regulations, and improved disclosures provide adequate protections against
conflicts of interest. These and other refinements should allow holding companies to move
closer toward their goal of operating as a one-stop financial service firm for customers, while
operating safely and soundly.
The Comptroller of the Currency has also taken steps to widen the breadth of
activities undertaken by banking organizations. For example, the expansion of insurance sales
activities has opened new opportunities for national banks.
Beyond efforts to reduce burden and modernize banking powers, regulators are
also redesigning their supervisory practices to address more effectively the changing nature of
the industry. These efforts are leading to a more risk-focused approach to supervision. That
approach is more responsive to the industry's rapidly evolving activities and risk profiles and
places emphasis on the institution's own ongoing system for managing risk, rather than
point-intime transaction testing. By focusing resources on the areas of highest risk, and eliminating
unnecessary procedures, this approach is not only more effective, but also less intrusive and
costly to all parties. I should note, however, that successfully implementing this approach
requires that supervisors attract, train, and retain qualified staff while also upgrading training,
automation, and other resources. This is a continuing challenge indeed!
Regulators are also trying to build on private sector initiatives that promote
safety, soundness and systemic stability. For example, at the height of Congressional concern
about financial derivatives, the Group of Thirty sponsored a study to identify principles of sound
practice for managing risks in derivatives for both dealers and end-users.
By providing guidance on this issue, that study served as a catalyst for industry
participants to analyze and evaluate their own practices. Subsequent guidance from the Federal
Reserve and the Comptroller benefited from the insights provided by the study, while adding a
supervisor's perspective.
The study's emphasis on education and sound practices spurred greater
understanding and acceptance by the industry of supervisory recommendations for sound risk
management systems. I think it is safe to say that this cooperative approach between the private
sector and regulators resulted in stronger industry practices and better supervisory oversight, not
only for derivatives, but also for bank risk management more generally. Together, the industry
and agency response helped stave off potentially restrictive legislation.
Another example of how supervisors are trying to build on bank management
practices is their use of internal value-at-risk models in the calculation of capital requirements
for market risk. By relying on internal models already used by the institutions for their trading
and risk management activities, regulators can reduce burden while vastly improving the
accuracy of the capital calculation. In addition, by embracing internal models for regulatory
purposes, supervisors are encouraging organizations to incorporate sophisticated risk models
more fully and formally into their risk management systems and to continue to upgrade and
improve the models.
As these two examples illustrate, supervisors recognize that they do not have all
the answers and that rigid regulatory solutions may often do more harm than good. A
supervisory approach that promotes continued improvements in private sector practices provides
the right incentives to industry and, in the case of banking, also reduces risks to the federal
safety net.
In these ways, supervisors are placing greater reliance on a bank's own risk
management system as the first line of defense for ensuring safety and soundness. We also want
to rely more on market discipline as another line of defense. This requires increased, improved
disclosure of a bank's activities, risk exposures, and philosophy for managing and controlling
risk. We have made significant gains for derivatives and market risks. Hopefully we will see
further gains in other areas in the years ahead.
While it is important for supervisors to identify risk at individual banks, as the
central bank the Federal Reserve must also be watchful for conditions and trends external to the
banking system that could place the financial system and the economy at risk. This broader
perspective has become especially important with the globalization of banking and integration of
markets. That is why the Federal Reserve has worked closely with financial regulators around
the world to reduce systemic risk and promote sound banking practices and improved
disclosures among both developed and emerging countries. These efforts have led to the
advancement by the BIS of core principles of bank supervision for authorities world-wide and,
significantly, promotion of consolidated supervision of banking organizations by home country
authorities. The issue of consolidated supervision is particularly relevant in revisiting the
question of the modernization of the banking system. I will come to that in a moment.
Financial Modernization and Umbrella Supervision
First I would like to point out that whether legislative agreement is reached or not,
market forces will continue the modernization of the financial services industry and will further
blur the lines between banks and nonbanks. For example, we can expect mutual funds to refine
their offerings to compete with bank checking and savings accounts, albeit without deposit
insurance. Banks will undoubtedly make further inroads in mutual fund management and
investment banking through internal growth and through acquisitions of securities firms.
Investment banks may also supplement their services by making commercial loans and
participating in loan syndications.
With such things happening, why do we need a legislative solution? The answer is
that a well thought out proposal addressing the appropriate structure for the industry would
allow for a more rapid and efficient integration of financial services. Moreover, by clearly
defining the boundaries and structure of financial conglomerates, a well-considered supervisory
program could adequately protect banks without undue intrusion to other parts of the
conglomerate.
Because financial conglomerates generally operate as integrated entities and
manage risks on a global basis across business lines, their true operating structure superimposes
a risk management and internal control process that extends across legal-entity-based corporate
structures. In this light, supervision by legal entity can create important supervisory gaps that
may expose the insured depository institution to unnecessary risk. That is to say, someone
should look at the risk management of the organization as an organic whole, rather than as
separate pieces that are simply added together. In fact, comprehensive, consolidated supervision
by the home country supervisor is a legal requirement for foreign banks operating in the U.S.
Some foreign supervisors are now beginning to question the consolidated supervision of U.S.
firms operating in their countries.
Now, I suspect some nonbank firms may feel apprehension at having an umbrella
supervisor evaluate their operations. But let me emphasize that such oversight need not be overly
onerous or intrusive. In fact, regulators are probably better prepared than ever before to
implement an umbrella supervisory approach as a result of the supervisory techniques and
approaches I just discussed. By applying risk-focused supervision, and promoting sound
practices, and improved market disclosures, an umbrella supervisor should be able to implement
an effective, unintrusive oversight process for conglomerates. Moreover, an umbrella supervisor
may be able to provide assurances and information to other regulators and individual supervisors
which may minimize their need to extend their reviews beyond the legal supervised entity and
into the conglomerate's other operations, creating duplication and burden.
I believe that the umbrella supervisor, whether it is the central bank or another
agency, should not attempt to duplicate efforts of other regulators. Rather, the umbrella
supervisor should evaluate the financial conglomerate from a more comprehensive perspective,
bridging the gap between an organization's legal structure and its structure for taking and
managing risk. Similarly, the umbrella supervisor need not attempt to extend bank-like safety
and soundness regulations to nonbank entities. Those standards were never intended to apply to
the nonbank entities of a conglomerate and would insert unnecessary competitive barriers
without achieving the desired benefits.
How exactly should an umbrella supervisor meet its responsibilities? First by
focusing its supervisory efforts on the adequacy of the risk management and internal control
process of the parent company and of the group as a whole, and determining how well those
systems protect the safety and soundness of affiliated banks. That evaluation could be performed
in a manner similar to that of a securities analyst, albeit from a different viewpoint. This
assessment might involve analysis of public financial statements, rating agencies and Wall Street
analyst reports, internal management reports, internal and external audit reports, meetings with
management, and only limited, if any, on-site inspections of nonbank affiliates. Any visits that
are made could be limited to testing the adequacy of management and operating systems, to
protect the insured depository institution.
While various approaches could be taken to address capital adequacy and to avoid
the unnecessary or inappropriate use of double leverage, I believe such approaches should be
measured against the goal of assuring the safety and soundness of the affiliated banks. And
finally, the umbrella supervisor should have appropriate enforcement authority, including the
authority to require the sale of the bank in extreme situations.
Conclusion
It is clear that the financial services industry is changing and that banking powers
must also change if banks are to remain competitive. The Board has long supported reforms and
strongly urges them today. However, changes such as these carry risks. It is important, therefore,
that change be introduced properly through legislative debate and by adopting proper safeguards
to ensure that nonbank activities do not unduly expose banks and taxpayers.
The Federal Reserve is mindful of regulatory burden and of the need to
accommodate change. Nevertheless, we also believe that some type of umbrella supervision will
be necessary to protect insured depository institutions and address systemic risk concerns.
Whoever plays that role should take a broad perspective in evaluating risks not only to specific
depository institutions but also to the payment system and to the broad financial industry as well.
Simply put, I believe that in an economy as complicated and integrated as we have in the United
States, it is important for the nation's central bank to have a significant role in comprehensive
financial institution supervision.