Mr Crockett considers what regulatory consequences should be drawn from the most
recent crises in financial markets
Remarks by the General Manager of the Bank for International Settlements, Mr Andrew
Crockett, to the European Banking Congress in Frankfurt/Main on 20/11/98.
You have asked me to talk about the regulatory implications of recent crises. Before I do so, it is
important that we understand the relative roles of regulators and bank management in avoiding
excesses and managing risks appropriately. As you all know, the regulatory and supervisory
focus has shifted in recent years from quantitative controls and explicit rules to monitoring bank
soundness through the quality of internal controls and the banks' risk management culture. With
this, greater emphasis has been placed on responsibility of bank management and stakeholders,
through market discipline, to ensure prudent operations. I think we all agree that bank managers
and market participants are better equipped and 'incentivised' for this task than supervisors. And
there is no going back to a world of quantitative controls.
At the same time, it is understandable that the ability of banks to repeatedly walk open-eyed into
massive overexposure should lead to questions being asked about the wisdom of this change in
regulatory and supervisory focus. I will not address this question here. But if the banking and
wider financial community is to resist pressures for re-regulation, it is necessary that it should
pay much greater heed to the responsibilities for prudent operations that are now more explicitly
theirs and theirs alone.
What regulatory consequences should be drawn from the most recent crisis in the
financial markets?
Coming to the question you asked, I think it is useful to distinguish between the crisis in
emerging markets and the recent heightened volatility in financial markets in advanced
economies. Even though there are undoubted linkages between them, the regulatory implications
to be drawn are rather different.
Concerning what has happened in emerging markets, there are at least three basic lessons from
recent experience. The first is that structural weaknesses in the financial system can be very
costly. The second is that there are important feedbacks between macroeconomic instability and
problems in the financial sector. And the third is that financial instability can spread contagiously
from country to country. The Asian crisis began when the overvalued Thai baht had to be
devalued. The currency crisis then interacted with financial system weaknesses to produce a deep
economic recession. And the difficulties in Thailand were rapidly propagated across the region
and beyond.
From this experience, the most important regulatory consequence to be drawn is the need for
rapid strengthening of financial systems. Among the most important shortcomings of financial
systems in Asia were: severe currency and maturity mismatches; excessive concentration of
lending; insider and politically directed lending; inadequate accounting and loan classification
procedures; weak capitalisation; and unsatisfactory supervision.
Correcting these fundamental problems will be neither quick nor easy. A strong financial system
requires the development of deep-rooted 'credit culture', in which lending instruments are
properly related to the risks they are used to finance. Lenders need to become better able to
assess borrowers on an arm's-length basis, understanding their businesses and their various risks,
matching cash flow to debt servicing obligations and appreciating the appropriate role of
collateral. And supervisors need a strengthened capacity to identify and correct sources of
vulnerability.
Fortunately, there now exists a standard by which banking systems and supervisory arrangements
can be judged. This is the 'Core Principles for Effective Banking Supervision' issued last year by
the Basle Committee on Banking Supervision. Virtually all countries have now accepted these
principles and pledged to adopt them. This is not the place to go into the Core Principles in
detail. But let me just note four aspects of them that are of key importance. First, they cover all
phases in the life of a bank, from initial licensing, through ongoing supervision, to eventual
closure procedures. Second, they apply to both domestic and internationally active banks. Third,
the rules are applicable to banks operating in emerging markets as well as to those of industrial
countries. And fourth, they have been developed by an internationally representative group of
supervisors. The Core Principles therefore have the comprehensiveness and the legitimacy to act
as the basis for a thorough-going strengthening of banking systems worldwide.
The difficult part, of course, will be implementation. A major effort will be required involving
banks, national supervisory authorities and international organisations and expert groups. The
BIS and the Basle Committee will play their part both in implementation and in providing
training and technical assistance to help countries bring their systems up to scratch. Although
primary responsibility for overseeing implementation of the Principles falls to the IMF, the Basle
Committee will be drawing up a compliance methodology for use by the IMF in its surveillance
activities. And as regards training, we have recently announced the establishment of the BIS
Financial Stability Institute, which will be headed by Mr John Heimann, who is well known in
the banking community and Mr Erik Musch, former Secretary General of the Basle Committee. I
hope this Institute will make an important contribution to disseminating best supervisory practice
and supporting the effort to strengthen banking systems.
I now turn to the lessons to be learned in the industrial countries from the rather extraordinary
episode of market turbulence that began in mid-August. The Russian debt moratorium of
17 August sparked a widespread flight to quality, which was followed by a generalised drying-up
of liquidity in many markets. This prompted fears that lenders would 'disengage', leading to a
credit crunch.
Fortunately, markets have more recently gained a certain measure of stability. But we should
certainly try to understand what went wrong and how we can avoid such episodes in the future.
One problem was that lenders had unrealistic expectations about the extent to which their loans
to emerging markets would be protected. It is therefore important that cross-border lending be
assessed on a stand-alone basis, and that supervisors make sure that the pricing and management
of such exposures are not undertaken on a false basis. In other words, a tightening-up of credit
risk procedures is called for.
Another source of difficulty was that the models used to assess market risk were based too
simplistically on established statistical correlations. They did not take adequately into account
other types of risk, such as liquidity, volatility and event risk. Widely used value-at-risk models
caused financial intermediaries to liquidate assets when volatility in asset prices increased. This
selling, in turn, caused volatility to increase further and resulted in additional selling. The fact
that most market participants used the same basic model led to common reactions, amplifying
herd-like behaviour. Consideration therefore has to be given to ensuring that common behaviour
by market participants does not exacerbate market instability.
It has to be recognised that all model-based approaches to controlling market risk embody
assumptions, explicit or implicit, about market liquidity. The drying-up of liquidity in periods of
market turbulence, as market participants seek to disengage from exposure, invalidates a basic
premise on which risk management is built. It is therefore all the more important that VaR-based
approaches to risk containment are supplemented by stress-testing.
How do you think national governments have fared in implementing BIS rules?
The scorecard in this connection is not very good. If one looks back at the history of the past 10
or 15 years, financial crises have succeeded themselves with depressing regularity. In the
emerging markets, there are [15] cases in which the direct resolution costs of banking sector
crises have exceeded 10% of GDP. And among the industrial countries, systemic strains have
been just as evident. The Savings and Loan debacle in the United States; the Scandinavian
banking crisis; financial fragility in Japan; and individual cases of failure or severe difficulty,
such as Barings and Crédit Lyonnais: all these episodes show there is much to be done in the
advanced countries also.
Let me make a few simple points:
First, capital ratios do not mean much without prudent and consistent accounting practices. Time
after time, banks have failed even though they had shortly before declared strong capital ratios.
And whole banking systems have been declared sound at a certain moment, only to have severe
weaknesses revealed shortly afterwards. The reason, of course, is accounting practices that allow
bad loans to be called good. It is of the utmost importance that asset impairment is quickly
recognised.
Second, the Basle rules are not just a matter of capital requirements. Banking is about the
management of risk. Banks need systems and controls at all levels that foster the accurate
measurement and monitoring of risk, and permit risk to be accurately priced and rigorously
controlled. This goes well beyond the maintenance of certain balance-sheet ratios which, we all
know, are at best an imperfect measure of the riskiness of a portfolio.
Third, good supervision is no substitute for a developed 'credit culture'. The best supervisors in
the world cannot enforce a culture when the basic soil is not receptive. As I noted earlier, the
onus here lies squarely with banks' management and their boards of directors.
Fourth, to keep a banking system healthy, it is necessary to have clear procedures for dealing
with institutions that get into difficulties. Too often, troubled banks are allowed to remain in
operation as losses mount and their capital erodes. Forbearance is used to put off difficult
decisions in the hope that things will somehow get better on their own. Industrial countries have
been just as guilty as developing ones in this regard. Early intervention procedures therefore need
to be spelled out so that institutions in difficulties are dealt with before they infect the rest of the
system.
Let me conclude: the international financial system has had a close shave. With luck, and skilful
management from now on, there is a good chance that things will now get better. But there are
important lessons to be learned if the system is to be made more resilient on a durable basis.