William J McDonough: Bank supervision and credit standards under Basel II -
perspectives for SMEs
Remarks by Mr William J McDonough, President and Chief Executive Officer of the Federal Reserve
Bank of New York and Chairman of the Basel Committee on Banking Supervision, at the Gürzenich
Köln, Cologne, Germany, 25 April 2002.
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Introduction
Graf von Hohenthal, Herr Dr. Breuer, members of the panel, "meine Damen und Herren..."
It is an honor to join your discussion on the efforts of the Basel Committee on Banking Supervision to
ensure that the international rules on capital adequacy serve the needs of twenty-first century banking
effectively.
What makes this a special privilege for me is the opportunity to meet so many entrepreneurs, owners
of small and medium-sized businesses, and others who make up the real engines of the economy.
Your interest in the work of the Basel Committee reminds us all that we must look beyond the banking
sector to ensure that the foundation we lay provides for the stability and growth of the entire economy.
I have long emphasized that the role of supervisors is not to hinder growth or profit, but rather to
promote the responsible pursuit of opportunity and innovation. As we improve the rules for bank
capital, we must certainly keep this mandate in mind and consider the effects that changes to those
rules may have on the economy.
Like you, I recognize the need for small and medium-sized enterprises to retain access to credit at
reasonable and fair prices. Access to credit matters not just because credit can enable small
businesses to grow, but more because small businesses enable the whole economy to grow. This is
true not just for the "Mittelstand" in Germany, but also of entrepreneurial ventures around the world. In
the United States, for example, small businesses traditionally create the majority of new jobs, invent a
large proportion of all new technologies, and are responsible for nearly 40% of our gross national
product.
Preview
I know that you are deeply interested in the steps that the Basel Committee is taking to ensure that
small businesses continue to enjoy fair and open access to credit, and I am pleased to share with you
the good progress that the Committee has achieved since the release of the Second Consultative
Paper in January 2001. I'll begin with an overview of the importance of regulatory capital to the stability
of the banking systems - and that of the economy - and how the Committee's current efforts will
reinforce that stability. Second, I'll discuss some changes that are of particular interest to banks that
lend to smaller businesses and to owners of small and medium-sized enterprises as well. I would like
to close by giving you some insight into the process and the timeframe that is guiding our work to
complete the impact studies and to move toward release of the final Consultative Paper. At that point, I
look forward to hearing and learning from you in what I hope will be a rich discussion session.
Purpose of regulatory capital
First, let's look back for a moment to understand the path we've taken. The Basel Committee has long
sought ways to ensure that banks hold sufficient capital relative to the risks they face. Capital, of
course, helps individual banks to weather unexpected losses. On a macro scale, requiring all banks to
maintain adequate levels of capital helps to safeguard the stability of the financial system. When a
financial system is more stable, banks are better able to provide businesses and consumers with
funding and credit through good times and bad, which promotes the long-term growth of the economy.
The risks involved in lending and borrowing have long been recognized, "For [a] loan oft loses both
itself and friend," warned Shakespeare some centuries ago. For their part, banks - like all companies
- seek a healthy balance between risk and opportunity. Because banks serve as key intermediaries of
credit within the economy, poor credit decisions harm not just banks, but borrowers as well. Overly
restrictive terms for credit make loans less accessible to all businesses, impeding their ability - and
that of the economy - to grow. If the terms for credit are too lax, loans may be extended in volumes
that borrowers ultimately may be unable to repay in full. In such circumstances, both borrowers and
lenders may experience losses and bankruptcies, depleting the future supply of credit. A banking
system that encourages lending to companies or individuals in excess of their ability to repay is one
that hurts not just borrowers, but society as a whole.
Goal of the New Accord
In promoting the efficient use of banks' capital resources, the member countries of the Basel
Committee are revising a now outdated international agreement on the minimum level of capital banks
are required to hold. That original 1988 agreement was relatively uncomplicated and represented an
important first step in the development of an internationally acceptable standard. It has since been
overtaken by advances in the financial sector - and in the economy. New technology, the globalization
of financial markets, and innovative financial products and services have changed the way that banks
measure and manage credit, market, and operational risks in a manner that the 1988 Accord could not
anticipate. Let me be clear about this: the 1988 Accord is broken. It no longer meets the needs of
sophisticated, twenty-first century markets. The new Accord will do just that.
Our goal for revising the Accord is to go beyond a rules-based structure and instead encourage banks
themselves to identify, measure, and manage their risks appropriately. In particular, banks making use
of the most sophisticated approach in the new Accord will increasingly be able to rely on their own
internal ratings of credit exposures when determining how much capital to hold. A key part of this work
is to provide banks with the appropriate incentives to improve constantly their processes for measuring
and managing risk. In doing so, I believe that we are able to reinforce the stability of markets. In this
regard, I am reminded of Goethe's view when he asked, "What government is the best? That which
teaches us to govern ourselves." In a similar manner, I believe that the new Accord will motivate banks
to enhance their understanding of the risks they face and seek better ways to manage them.
Because the changes proposed are far reaching, the Basel Committee is working collaboratively and
publicly with supervisors, banks, and others involved in the financial sector. We've released thousands
of pages of proposals and studies for public review and comment. The weight of those volumes
demonstrates how hard we've been working and how complex the challenge has been. We are
meeting with industry participants and others in a variety of formal and informal settings, such as this
gathering tonight, to exchange views on the proposals. My colleagues and I have been enormously
appreciative of the comments and questions that we've received and are very impressed with the
quality of those views. Our proposals have been strengthened and improved by the public consultation
process.
Based on the comments we've received, I believe that the industry very much shares our goal of
aligning regulatory capital more closely to risk. Other market participants are likewise supportive of our
efforts to develop an Accord that remains robust, relevant, and responsive to the demands and
innovations of modern banking. Work on the proposal is continuing, and the Committee is currently
addressing several important issues, including how the revised Accord may affect loans made to small
and medium-sized enterprises.
Changes since the Second Consultative Paper
In countries around the world, and especially in Germany, much has been written about the effects the
new Accord may have on the cost of credit for small businesses. I believe that, over the past year,
we've made substantial progress in finding solutions that should alleviate those concerns for small
business owners, regardless of whether they run a small high-tech consulting firm or a "BMW"
("Bäcker, Metzger und Winzer")-firm. I'd like to focus on changes to the internal ratings-based ("IRB")
proposals that are relevant to small and medium-sized businesses. Changes concerning the treatment
of loans to small and medium-sized enterprises include (a) modifications to the capital requirements so
that they better reflect the underlying risk; (b) greater recognition of collateral provided by small and
medium-sized enterprises; and (c) an adjustment to the capital charges based on a borrowing firm's
size. I will also discuss proposals related to banks' equity - or venture capital - investments in other
firms.
Modified capital requirements
Let me begin by explaining what we are doing to ensure that the capital held against loans made to
small and medium-sized companies is truly reflective of risk. The Committee has on two occasions
over the past year asked banks to assess the impact of the revised Accord. The data gathered have
enabled us to evaluate the level of capital that our proposals would generate and to consider several
modifications.
As you may know, our early findings suggested that the internal ratings-based approach as outlined in
the Second Consultative Paper would have required banks to set aside too much capital. Contrary to
the Committee's clear intent, banks would not have received a capital incentive for adopting this more
sophisticated approach to capital adequacy. As a result, we had to adjust the capital requirements to
provide banks with the right incentives under the new framework.
The Committee's aim is to avoid unintended consequences stemming from the new proposals. That's
why we are taking additional time to make sure our proposals are right. To this end, we published in
November a change in the IRB formulas for calculating bank capital requirements. This change -
based on the Committee's internal research as well as additional input by bank risk management
experts - reduces the extent to which capital will vary with the internal ratings banks assign to their
exposures. One consequence of this important change is a reduction of around one-third in the capital
charges on loans to many small and medium-sized businesses, relative to what the Committee had
proposed in January 2001.
Greater recognition of collateral
A second change, announced in November, is to expand the range of acceptable collateral to let
banks that qualify for the internal-ratings based approach recognize physical collateral and trade
receivables as a way of reducing their capital requirements. The Committee is aware that small and
medium-sized enterprises, such as the "Einzelkaufleute" and "GmbH," tend to pledge these forms of
non-financial collateral when they apply for credit. By treating collateral in this way, the Committee
estimates that IRB capital requirements on loans to smaller companies may fall by another 10 percent
relative to the first change I mentioned.
We face a challenge in determining which forms of collateral or trade receivables offer the greatest
level of protection to banks compared to other forms. This is not an easy task because each type of
collateral has a unique historical record in reducing loss, records that also vary according to country.
Moreover, banks in different countries manage collateral and trade receivables in very different
manners.
Because of these differences, we believe that national supervisors are best suited to determine which
sorts of collateral to accept in their respective markets. Rather than having the Basel Committee draw
up a comprehensive list of permissible instruments, we are developing a set of minimum criteria for
national supervisors to implement. I believe, particularly in the case of physical collateral, that banks
using the internal ratings-based approach must obtain a timely, third-party view of the collateral's
value. One test, for example, is that should the need arise, the bank must be able to dispose of it with
relative ease. As a former commercial banker, I cannot see how any responsible banker would be able
to sleep at night if these conditions are not met. On the other hand, it seems clear to me that if these
conditions are satisfied, then the collateral does offer a bank protection against loss and banks will
need to hold less capital against those loans.
Let me try to anticipate an immediate question you may have. What do we expect will be the net effect
of the changes I have discussed? I believe that the impact of more risk-sensitive proposals will be very
positive for small and medium-sized businesses in many countries. I understand that Jochen Sanio,
the very capable President of the BAKred and, as of the first of May, President of the newly
established FSA, expressed a similar view at a recent parliamentary hearing. He pointed out that
based on our current proposals, on average, German banks' exposures to small and medium
companies would require less than the 8% capital currently needed under the 1988 Accord.
But the issue is not simply a question of impact. The principal motivation behind the Basel
Committee's efforts has been for bank capital requirements to take appropriate account of risk. In this
regard, the Committee has over the last six months been engaged in a significant research program to
assess whether the size of a borrowing firm should be explicitly considered when banks calculate their
capital requirements.
At this point, the Basel Committee is discussing whether and how to factor a firm's size into the new
framework. A lower capital charge for a portfolio consisting mainly of loans to many small companies
makes economic sense because that portfolio is likely to be better diversified than one concentrated in
loans to a handful of large companies.
Assuming the discussions within the Basel Committee continue to proceed in this direction, it means
that loans to small and medium-sized borrowers would have lower capital requirements than loans to
larger companies that are otherwise rated the same.
One point should be made about the treatment of loans to small and medium-sized enterprises. The
Basel Committee wishes to ensure that our new framework reflects the sound risk management
practices of banks. For example, many banks manage and evaluate their loans to smaller businesses
in a way that is similar to the way they handle consumer loans. The design of the internal
ratings-based framework will, therefore, allow a number of such loans to be treated like retail credits,
as opposed to corporate loans.
This principle also will apply to another important issue within our capital framework, namely the role of
a loan's remaining maturity. The Committee is sensitive to the concerns raised about the need to
respect the long-term lending culture prevalent in a number of countries. In this context, we will
examine carefully how, or even whether, maturity factors should apply to lending to smaller
businesses.
Treatment of equity exposures
The changes I have referred to concern bank loans, which, of course, are a key source of funding for
many companies. Nearly all businesses - especially those growing into medium or large-sized firms -
also rely on investments from outside parties to build up their capital base. Here, I'm referring to
outsiders who provide "venture capital" for growing firms, as well as to investors who buy the publicly
traded stock of more established firms.
What do I mean by venture capital? Many small firms seek an "angel" investor, one who sees the
potential in the firm's strategy and is confident enough of its success to make a substantial investment.
The angel might be a single wealthy individual, an investment fund or, in some cases, even a bank. In
exchange for the investment, the investor receives an ownership interest in the income and assets of
that firm.
The Basel Committee recognizes that both venture capital and equity investments often are catalysts
for innovation and growth in the economy. At the same time, we recognize that such investments can
represent high-risk activities for banks. Consequently, the new rules are being designed to recognize
the underlying risk while not discouraging or penalizing banks that wish to remain involved in venture
capital and equity investing.
Our goal is to create a capital approach to equity exposures that builds upon sound internal bank
practice and remains flexible enough to apply in any country. Our challenge is to develop a treatment
that makes sense today and that will be responsive to the evolution of banks' practices in equity
funding.
An equally important consideration is implementation, given significant differences in the nature of
banks' equity holdings across countries and in the ways in which capital markets have evolved over
time in each country. The Committee wants to avoid disrupting equity holdings that have developed
under existing capital regulations --- whether these are long-term holdings, such as in Germany, or
those associated with small business investment corporations in the United States. To this end, only
new equity investments would be captured under the internal ratings-based approach for the first ten
years after the date that the new Accord is implemented.
This is an area where the Committee has tried to navigate differences between national practices. We
see the best way forward as offering two approaches to calculating regulatory capital for banks' equity
exposures, one based on measures of market risk and a second based on the treatment of corporate
loans. In either case, we intend for both methods to result in comparable capital requirements, which
we will seek to confirm through our next impact study. Responsibility would lie with the national
supervisor to determine the approach most suitable for its banks.
We expect that the new capital treatment will provide much better support for the healthy growth of
equity financing and venture capital markets than the current Accord.
Summary of changes and need for standards
These important changes - modifying the capital charges, permitting greater recognition of collateral
and trade receivables, and increasing the flexibility of the treatment of equity - should go a long way
toward ensuring that banks that lend to small and medium-sized businesses are not disadvantaged
under the internal ratings-based approach of the new Accord. I'd like to take a moment to speak more
broadly about the internal ratings-based approach.
I think it is a significant and innovative step for banks' internal ratings to play a major role in their
capital requirements - a step that plays very strongly into our goal of better aligning capital
requirements and risks. To do this effectively, we need to ensure that a bank's internal rating system
enjoys an appropriate degree of credibility and consistency when used in determining regulatory
capital. Accordingly, we are striving to develop a meaningful set of minimum standards.
While I have focused on the first "pillar" of the new Accord, namely the minimum capital requirements,
it's important to remember that there are two other pillars vital to the new framework: supervisory
review and market discipline. I would be happy to talk about them during the discussion if you would
like to hear more.
Timing of the New Accord
Let me close by telling you where we are in the process. To make sure that we get the new Accord
right, members of the Committee and I felt it was important to continue to solicit and evaluate feedback
from the industry in a variety of ways. Empirical exercises (or the quantitative impact studies as they
are called) will be an important part of this dialogue, both those underway now and the more
comprehensive study that will be undertaken in October.
The exercise we are designing for the autumn will provide banks with the opportunity to assess the
impact of a fully specified proposal. It will be targeted to a wide set of banks worldwide, after which,
the Committee will release its proposal for a third and final round of formal consultation. We expect the
consultation will be relatively brief given all of the discussion and assessment that has taken place.
Let me stop here. I would be delighted to answer your questions.