Mr. Meister asks whether supervisory capital standards should be modernised
Luncheon speech by Mr. Edgar Meister, a member of the Board of the Deutsche
or redesigned
Bundesbank, at the Conference entitled "Financial Services at the Crossroads: Capital Regulation in
the 21st Century" orrganised by the Federal Reserve Bank of New York, in New York on
26-27/2/98.
I
I am delighted to have been given the opportunity of speaking to such a highly
qualified audience at this major conference on capital regulation.
If you see a banker jump out of the window, jump after him - there is sure to be profit
in it, said Voltaire, the 18th century French philosopher. Looking at the situation in South-East Asia,
I am not entirely convinced that it would always be wise to follow Voltaire's advice. Even if all
banks do the same thing, that does not necessarily mean that it is appropriate.
It is also becoming clear, however, that the Asian crisis has lent new points of
emphasis to the already important topic of capital adequacy; in other words, risk and capital. In that
respect, this conference has come at a very opportune moment.
What we have to consider is whether the concept of the capital accord, which dates
from 1988, is still appropriate for meeting the challenges of the 21st century in terms of a good
prudential supervisory standard? Or do we need an alternative system, and which alternative system
of capital requirements might be superior to the present one?
There are divergences of opinion on this matter not only between the supervised
institutions and the supervisors but also, in some cases, among the supervisors themselves.
In order to assess both courses of action (modernise or redesign), it would appear to
be the obvious approach to use current, accepted criteria in the field of prudential supervision. These
include:
The security level of the individual institution, i.e. its capacity and expertise in managing
risk and its cushion of capital against losses. And closely linked to that: the overall
stability of the banking system. I assume nobody wants a level of financial market
stability that is lower than now.
as well as
The regulatory burden and level playing field aspects. Streamlining supervision and
deregulation are important additional conditions for avoiding competitive
disadvantages caused by banking regulation and for optimising the supervisory
system on cost-effectiveness criteria. The regulatory burden cannot be the main
deciding criterion, however. Furthermore, prudential measures should not themselves
create competitive discrepancies between different groups of banks.
II
In terms of considerations of risk, an ideal capital standard should be designed to fully
reflect an institution's risks and to derive a capital base which takes due account of risk. At the same
time, it would be desirable if this standard raised market discipline. In reality, we are still too far
away from that theoretical ideal.
There are differences in the measurability and hence also in the controllability of the
main risks to which banks and other financial intermediaries are exposed. With the risk controlling
techniques that have now been developed and on account of the availability of the input data, market
risks, for example, can be measured quite accurately in most cases.
By contrast, in what is still the main risk area for banks, credit risk, a purely
quantitative determination of risk - comparable to market-risk modelling - is much more difficult and
has not yet been achieved. For that reason, assessment of the credit risk is still strongly marked by
traditional methods, i.e. the judgement of the banks' credit officers.
As we have heard before, the efforts to improve the quantification of credit risks (by
using models) are mainly hampered by the inadequate availability of data or their poor quality. For
that reason, the recent survey on data sources by the ISDA to develop a reference and liquidity
assessment for credit risk modelling is to be welcomed. It remains to be seen, however, whether the
quality of the data in major market segments will be adequate.
Operational risks, too, including - for example - inadequate segregation of duties,
fraud and errors in the field of data processing, are very difficult to model on account of the even
greater problems concerning data. Measuring these risks is therefore rather a combination of estimate
and guess; in other words, a „guestimate" which is largely based on data not objectively observable.
III
The difficulties in risk measurement are a problem for the institutions, but also for
prudential supervision for which it is difficult to define capital requirements.
Our existing regulatory framework aims, not least, to ensure that the institutions have
an adequate cushion of capital as a protection against unavoidable losses. Although this "shield" of
capital is supposed to cover all risk factors without them being broken down in greater detail (for
operational and legal risks, too, for instance), the calculation of the required supervisory capital is
essentially geared to risk factor: the default risk (and, to a lesser extent, the market risk, from
a single
January 1998 onwards).
Bankers and some supervisors have recently called the Capital Accord into question,
not least because of its inexact categorisation of risks. It is pointed out that exposures to OECD
countries are uniformly assigned a risk weighting of 0%, for instance, although there are considerable
differences in terms of risk within that group of countries. The same applies to exposures to
non-banks with a weighting of 100%, including blue chips that are known worldwide. Additionally, it
is claimed that the degree of diversification in the loan book is not taken into account. This is said to
result in a misallocation of funds since they are not used in the most productive way.
IV
This is the backdrop against which more sophisticated methods of credit risk
measurement are discussed, ranging from a subtly differentiated prudential weighting scheme, the use
of external or internal rating, the inclusion of portfolio effects and credit risk models to new concepts
completely different from the Capital Accord. It is my assessment that the supervisors are
fundamentally open-minded about these discussions. The new concepts include, in particular, the
pre-commitment approach and more self-regulation, as proposed by the Group of Thirty.
Pre-commitment implies that a bank decides itself how much capital it will hold
within a given period to cover the risks arising from its trading book. Sanctions will apply if the
accumulated losses exceed that amount. This idea is tempting in many respects. It could make things
easier for the supervisors and the regulatory burden would be lower for the institutions. Moreover
this approach is highly market-oriented.
There are a number of fundamental difficulties, however. The pre-commitment
approach involves a purely ex-post analysis of a bank's risk and capital situation. This perspective
results in supervisory authorities reacting rather than specifying a given level of capital for the
institution in a preventive manner. Without wishing to pre-empt this afternoon's discussion, I
perceive the danger of an institution accepting additional risks if there is a threat of the
pre-commitment being infringed and hence of regulatory sanctions. If there is a danger of the amount
of capital being exceeded, some traders will attempt to change course abruptly in accordance with the
dictum "If you are in trouble, double".
A key problem also consists in finding a consistent penalising mechanism. Assuming
that the risks taken result in the institution suffering losses higher than the earmarked reserved capital,
banking supervisors would have to impose penalties which would lead to the financial difficulties
being even bigger.
Furthermore, the market is to be informed of this for the purpose of strengthening
market discipline. It is, above all, this envisaged sanction - so it seems to me - which meets with
considerable reservations on the part of many institutions and supervisory authorities. I am quite
doubtful whether institutions would be prepared to go that far in terms of disclosure.
At the risk of exaggeration, and relating to the concept of the bank as a whole, the
pre-commitment approach represents a bank's promise that it will not become insolvent. If that
promise cannot be kept, it will remain an open question - at least in critical cases - whether the
supervisors can or will impose sanctions.
A proposal by the G-30, which goes further than the pre-commitment approach,
amounts to leaving supervision and the development of regulatory strategies basically to the market
or to a small group of major international financial institutions. The involvement of supervised
institutions in the development of regulatory standards is not new in principle. It has been tried and
tested. Whenever certain methods have become state of the art, supervisors have always been ready
to adopt such standards as binding - as was latterly the case for the recognition of internal models for
market risks.
Nevertheless, there may be problems, for example, if there are no administrative
sanctions to enforce the standards. How binding would they be? Trusting solely in an effective
market control, pre-supposes a comparatively high degree of transparency. As in the case of the
pre-commitment approach, it appears to be questionable whether all the market players would be
prepared to disclose their risk positions and losses to the market, for example. That would
simultaneously mean them revealing market expectations, trading strategies and other business
secrets.
Furthermore, it would not be greatly surprising if the interests of this select group of
institutions were not identical with the general interests of the financial industry. In particular, there is
the possibility of competitive distortions at the expense of smaller institutions. As mentioned above,
the possibility of supervisory standards, including voluntary self-regulatory standards in the private
sector, causing new competitive problems should at all events be avoided.
V
As concepts, the pre-commitment approach and self-regulation as proposed by the
G-30 can indeed supply important and thought-provoking ideas. Given the present prudential
standard, the advantages of these alternative concepts consist, for example, in a reduction of the
regulatory burden and banks having even greater freedom in their risk management by virtue of a
pronounced market orientation.
At the same time - in addition to the reservations already mentioned - I perceive the
danger of a decline in the overall security level of the individual credit institution and the banking
system. Existing risks might be covered by less capital than hitherto under the Capital Accord.
Self-regulation aiming at greater market discipline would be welcome. The alternative
concepts that have been referred to here would probably not be able to achieve that on a lasting basis
or especially if a bank or a banking system were in a difficult situation, and would not be able to
make up for the disadvantages of institutions having a lower capital base.
What should also be given consideration is that pre-commitment and self-regulation
as advocated by G-30 - is intended to apply mainly to large, internationally operating banks. These
are precisely the players who have an especially prominent role in terms of the stability of the
financial markets.
At the same time, we know that the world of risk has become more complex during
the last few years and that the risks which the institutions have to bear under the pressure to perform
have increased. Risky high-yield transactions in emerging markets, for example, are likely to become
increasingly significant in future despite the recent turmoil in Asia.
Precisely the events in South-East Asia demonstrate how difficult it is to determine
bank-specific risks with sufficient accuracy. Even leading rating agencies have tended to run behind
the markets in line with the maxim: "Please follow me, I am right behind you."
VI
Capital is therefore still a modern prudential requirement. The Basle Capital Accord
is, in this context, a rough and comparatively simple approach.
This standard, which has now been put into practice virtually worldwide, undoubtedly
has some weaknesses. It has however demonstrated its suitability under changing conditions in the
almost ten years since its introduction. In my view, the empirical findings are definitely positive.
However, the Capital Accord has not worked where the calculated capital was not
actually in place. I am referring to credit institutions in many countries which have experienced
crises. In such cases, some institutions only fulfilled the norm of 8% minimum capital.
formally
Actually, an evaluation of assets and liabilities in line with market conditions would have shown that
the capital had been used up long beforehand.
As the Capital Accord sets the capital requirements more conservatively than the
alternative approaches mentioned, there remains a buffer for cushioning the risks which are difficult
to measure - operational and legal risks, for instance. To that extent, an adequate cushion of capital
can to a certain extent make up for shortcomings in risk identification, measurement and control.
VII
To come back to the original question: I am in favour of an evolutionary solution. The
Basle Accord should be modernised and not - at present - be replaced by other concepts. There are
indeed other approaches which are worth discussing, but at present I cannot identify any convincing
alternative concept among them which would be operationally viable, practicable and superior to the
Capital Accord.
The Capital Accord itself is adaptable enough for new developments in the markets to
be integrated into its system in a meaningful manner - as occurred in the case of market risk, for
example. This also applies to all currently impending topics for discussion, such as on-balance-sheet
netting, credit derivatives, credit risk models and new capital elements.
In return, this also implies capital buffers becoming necessary for risks that have so
far not been covered: given an easing of capital requirements in other areas, buffers for operational
risks, for valuation risks and for concentration risks, for instance, must no longer be a "no-go" area.
Generally speaking, further qualitative requirements may also help to curb risks and
hence have a stabilising impact in micro and macro-prudential terms. In that respect, the Basle
Committee's "Framework for the Evaluation of Internal Control Systems" is especially important.
Quantitative and qualitative minimum standards for the use of credit risk models based on a widely
used and convincing practice would also have to be specified in due course.
In my view, self-regulation can have a stimulating effect, but it cannot replace an
administrative supervision of banks and other financial intermediaries. To that extent, self-regulation
is an approach which complements prudential supervision. I believe that this assessment is reinforced
by the various bank crises that have occurred in the past and has been borne out yet again by the
Asian crisis.
A basic stance of this kind virtually necessitates supervisors working closely with the
institutions. That is very helpful for finding regulations which are up-to-date and compatible with the
market and, at the same time, strengthen market discipline and do not lose sight of the stability of the
overall system.