William J McDonough: Update on the major initiative
to revise the 1988 Capital Accord
Speech by Mr William J McDonough, President and Chief Executive Officer of the Federal Reserve
Bank of New York, before the 4th Annual Supervision Conference of the British Bankers Association,
held in London, on 19 June 2000.
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I am pleased to be with you to provide an update on the major initiative to revise the 1988 Capital
Accord. Last June the Basel Committee on Banking Supervision, which I have the privilege of
chairing, released a Consultative Paper proposing a new capital adequacy framework. My comments
today will focus on the industry's response to the proposal and the areas that will require the
Committee's attention going forward. Given the progress already achieved, it is my belief that the
Committee will be prepared to release a second Consultative Paper early next year.
I will also briefly discuss three essential aspects of the safe and sound operation of any banking
organization - good corporate governance, rigorous internal controls and effective risk management. I
will conclude with some thoughts on the critical role of banks' board of directors and senior
management.
Current Accord
The primary tool of capital regulation currently is the set of minimum ratios that were devised in 1988
by the Basel Committee. The 1988 Capital Accord has truly become a global standard for banks
worldwide. Its adoption by over 100 countries has helped to strengthen the safety and soundness of the
international banking system and has contributed to the achievement of competitive equality.
However, the financial world has changed dramatically over the past dozen years, to the point that the
Accord's efficacy has eroded considerably. Its broad brush approach to differentiating credit risk
encouraged banks to undertake regulatory arbitrage transactions. Furthermore, as banks have
developed innovative techniques for managing and mitigating risk, credit risk now exists in more
complicated, less conventional forms than is recognized by the 1988 Accord, thus rendering capital
ratios, as presently calculated, less useful to banking supervisors.
Today's marketplace also provides an imperative for revising the 1988 Accord. The rapid pace of
technological change places information that was once largely the domain of analysts and institutional
investors into the hands of millions of individual investors and consumers. Market participants, armed
with timely and meaningful information, reward sound risk management practices and penalize those
banks that are found deficient in this area. A bank's regulatory capital position can be a strong
indicator of how it supports its risk, and if markets are to impose an optimal level of discipline on
banks, we must ensure that regulatory capital measures reflect risk as precisely as possible. I believe
that reform of the Basel Accord is thus clearly in the markets' best interests. As the Committee
continues to develop a more risk-sensitive capital adequacy framework, we cannot lose sight of the
need to keep the Accord up to date.
Progress in revising the Accord
Let me take a few moments to tell you how our work on the Basel Accord is progressing. The
Committee began a fundamental review of the Accord in 1998. The release last June of the
Consultative Paper reflected our vision for a new capital adequacy framework and we asked for
comments from the broad marketplace.
We knew that our first Consultative Paper would not be a perfect framework for all banks. That is why
we have been so keen to obtain feedback from a wide variety of sources including financial
institutions, central banks and supervisors, representatives from non-G10 countries and other market
participants. The formal comment period on the Consultative Paper ended on 31 March. We are very
pleased and encouraged by the response, and are now in the process of considering more than 200
comments received.
The commentators have sent us a strong message that they endorse our overall goal of developing a
capital framework comprised of three pillars - minimum capital standards, supervisory review and
market discipline - that is more risk reflective and appropriate to banks of varying levels of
sophistication.
Internal ratings-based approach
Based on our evaluation of the comments received, I can tell you that we are more committed than
ever to an internal ratings-based approach. Many in the industry noted that a capital regime based on
banks' internal ratings, which reflect a wide range of information about borrowers, can prove to be
quite sensitive to the level of risk in a bank's portfolio.
Our analysis indicates that a wider range of institutions could be eligible to use the internal ratings
approach, than the narrower set of large and sophisticated institutions, as implied in the Consultative
Paper issued in June. We now envision extending the applicability of the internal ratings method
approach to banks of varying sizes, including small and medium-sized institutions provided such
ratings systems are accompanied by strong internal controls, supervisory oversight and ample
disclosure.
With this in mind, the Committee is working on how to link banks' internal ratings to a regulatory
capital scheme. We are seeking to develop flexible approaches, since all banks wishing to use internal
ratings may not yet be able to generate the full amount of information necessary to tie their ratings to
capital requirements. Thus, for at least some banks, we are considering the possibility that some
information would be supplied by the supervisor, although the core elements would be generated by a
bank's internal ratings scheme. There would be a parallel track for the more sophisticated institutions,
which would rely fully on internal information. In practice, the two approaches are part of a single
evolutionary framework, in which banks can rely increasingly on internal processes for regulatory
capital allocation as their risk measurement and management practices improve.
As a first key step in developing these approaches, the Basel Committee gathered information about
banks' internal ratings systems. Our findings indicate that there is presently no single standard for the
design and operation of such a system. Thus, I see the importance of establishing appropriate
guidelines for the use of internal ratings systems. These guidelines should ensure that internal ratings
appropriately reflect the credit risk in each category of exposure. Additionally, it is important that we
develop robust disclosure guidelines for internal ratings information to ensure that capital
requirements are comparable across banks and countries.
Standardized approach
A revised standardized approach is still very important to us at the Basel Committee, as some banks
may not have the internal resources to implement an internal ratings-based approach, and some
supervisors have indicated that implementation of this approach would create resource strains for
them. Further, we want to ensure that those banks that look to the Accord as the common standard
many of which are located in emerging market countries - can subscribe to the revised framework.
In order to improve the risk sensitivity of the standardized approach without becoming overly
complex, the Committee has proposed the use of external credit assessments, such as credit ratings.
Many comments noted drawbacks to this approach, but those that have seriously considered the
trade-off between simplicity and risk sensitivity generally have agreed with the Committee's decision
to make use of external credit assessments. This is particularly true for sovereign credits where there is
widespread support for finding an alternative to the current OECD/non-OECD distinction. In other
words, OECD membership would no longer be relied on for setting regulatory capital for sovereign or
bank claims.
Notwithstanding this support, many commentators have offered modifications to the Committee's
proposed standardized framework, which several observers have suggested does not go far enough
toward risk differentiation. The Committee has taken this concern to heart, and is actively evaluating
whether it would be feasible to incorporate additional risk weights into the standardized approach, and,
if so, how this should be done.
As we work toward greater risk differentiation among claims that are rated, we will continue to give
extensive thought to the treatment of unrated claims, given that the penetration of external ratings
remains low in most countries. It is difficult to avoid creating incentives to remain unrated while at the
same time retaining continuity with the existing Accord's treatment for these credits. Further work
would be needed to develop a standard for unrated claims that would be more risk-reflective but,
unfortunately, few commentators offered significant suggestions in this regard.
Procyclicality
The Committee has considered what some observers have noted is the potential for introducing greater
cyclicality in a more risk-sensitive capital framework. That is, the capital requirements for loans to
troubled borrowers will tend to increase at just the point when such trouble is becoming apparent.
This is an important point, and one that must be given serious consideration. It is my view that the
global financial system needs to move toward addressing potential credit problems preemptively
before these problems have time to grow from minor disturbances to major disruptions. A more
risksensitive capital framework should help ensure that banks hold appropriate capital behind high-risk
credits in the first place, and thus reduce the tendency for accentuating the need for capital after
problems arise with such loans.
Credit risk mitigation techniques
Greater recognition of the benefits of risk mitigation techniques - such as collateral, guarantees, credit
derivatives and netting - also is at the forefront of the Committee's work in revising the Accord.
In January of last year, the Committee held consultations with over 50 banks and industry associations
within the G10 on their methods for mitigating credit risk. We are now evaluating how to incorporate
the risk-reducing benefits of the best of these practices, while at the same time addressing potential
risks that remain from their use.
As we finalize our proposals for making capital charges reflective of risk mitigation techniques, we are
striving to find the right balance between recognizing a material reduction of risk with a structure that
is applicable beyond internationally-active banks to both domestic and non-G10 banks. While we
recognize that the treatment of credit risk mitigation techniques might differ in some respects between
the standardized and the internal ratings-based approaches, we want to ensure a high degree of
consistency between the two.
Interest rate and other risks
The Committee recognizes that in refining the measurement of credit risk, we should also take the
opportunity to explore the potential coverage of other important risks, such as interest rate risk in the
banking book and operational risk.
For interest rate risk, we are pursuing a methodology that would require a capital charge only for
so-called "outlier" banks whose interest rate risk is significantly above average. The envisioned
framework for determining "outlier" banks for interest rate risk is similar to the general framework for
credit risk - the most sophisticated banks would use internal measurement systems for assigning
capital, while banks without sufficiently robust internal systems would use a simple standardized
approach. The Committee is still working out a number of issues on this topic, including the definition
of an "outlier" bank and supervisory assumptions that would need to be built into the standardized
approach.
The Committee, through its Risk Management Group, also is engaged in the development of a capital
requirement for other risks, in particular operational risk. Over the past year, it has met with numerous
banks and industry associations including the British Bankers' Association. These meetings have
allowed us to better understand the range of practices currently in use. Over the next year, the Risk
Management Group will work with the industry to develop an evolutionary framework comprised of
approaches of varying sophistication, ranging from a simple to an internal-based method. We are
particularly interested in creating the right incentives through a set of robust criteria that will enable
banks, subject to supervisory approval, to employ increasingly sophisticated approaches for setting
capital requirements for other risks.
Second and third pillars
Let me also briefly touch upon the two other pillars of the revised capital adequacy framework
supervisory review and market discipline. These topics are certainly familiar and important ones to all
of you.
Supervisory review of capital is a critical complement to minimum capital requirements. The
Consultative Paper proposes that supervisors should ensure that each bank has sound internal
processes in place to assess the adequacy of its capital, based on a thorough evaluation of its risks. I
want to stress that this proposed approach in no way intends to replace the judgement and expertise of
bank management, or to shift responsibility for capital adequacy to supervisors. On the contrary, it is
well understood that bank managers have the most complete understanding of the risks their
institutions face, and it is they and the bank's board of directors who have primary responsibility for
managing those risks.
The task for supervisors in this framework is to evaluate how well banks are assessing their capital
needs relative to their risks, including whether banks are appropriately addressing the relationship
between different types of risks. Most importantly, in proposing this second pillar the Committee
intends to foster a more active dialogue between banks and their supervisors, such that when
deficiencies develop, prompt and decisive action can be taken to restore capital. The Committee
currently is in the final stages of preparing a paper on how the supervisory review of capital can be
implemented effectively.
The third pillar of the new capital adequacy framework, market discipline, will serve to reinforce
capital regulation and other supervisory efforts to promote safety and soundness in banks and financial
systems. The Committee, in January of this year, issued a paper on bank disclosures, covering banks'
capital structures, risk exposures and capital adequacy. Currently, our Transparency Group is
considering whether it is possible to establish a set of core disclosures that would bolster market
discipline. This will involve drawing upon our existing disclosure recommendations, and reviewing
the extent to which disclosure in new areas - the internal ratings-based method, external ratings or
internal assessment of other risks - might be appropriate.
I hope that this overview has given you a sense of the key points the Committee has learned from the
consultative process, and where we are headed. In the near-term, we are completing our work and
expect over the next few months to make progress in a number of areas, including greater risk
differentiation in the standardized approach and the development of supervisory standards for internal
ratings.
As we continue to fine-tune the new capital adequacy framework, we also are striving to avoid getting
bogged down in secondary issues that could slow down the overall process. As I have often remarked,
the perfect cannot be the enemy of the good. It is imperative that we stay on track in our goal to
release a new capital adequacy framework by early next year, with a comment period and industry
implementation to follow shortly thereafter.
Corporate governance
My remarks thus far have focused on the need for a more risk-reflective capital framework. Clearly, a
strong capital position is crucial to the sound operation of any banking organization. It allows banks'
board of directors and senior management to focus on strategic objectives and growth opportunities,
supports the business activities of the organization, and provides the financial strength necessary to
sustain the occasional losses that are inevitable in a business of taking calculated risks.
In this latter sense, capital represents the last line of defense against potential loss-creating problems.
But, I want to briefly address the first line of defense - effective bank management, which increasingly
is an important element of today's supervisory framework as banks' activities and their associated
risks become ever more complex.
There are several aspects to effective bank management. The importance of good corporate
governance cannot be overemphasized. Broadly speaking, corporate governance refers to the
organizational infrastructure necessary to achieve a workable corporate strategy, to effectively
implement that strategy, and to continually evaluate its risks and benefits to the organization. These
basic infrastructural elements include:
- independent and competent outside directors;
- capable and experienced management;
- a coherent corporate strategy and business plan; and,
- clear lines of responsibility and accountability.
There are three key points that are closely related to good corporate governance and critical to any
banking institution. The first is a rigorous internal control apparatus, which is essential to the sound
and successful execution of banks' strategic objectives. Second, each banking institution must have in
place the technical systems and management processes necessary to identify the risks associated with
its activities. Third, an effective risk management and control structure must be accompanied by the
institutional management culture required to ensure that policies and procedures are translated into
practice, with buy-in at all staff levels.
Primary responsibility for ensuring that the bank has in place good corporate governance, rigorous
internal controls and effective risk management lies with the board of directors and senior
management. The task of the board of directors is to oversee the development of the overall strategy of
the organization and the decisions made by senior management in pursuit of that strategy. The role of
senior management, in turn, is to assure that day-to-day decisions made within the organization are
consistent with the policies and long-term objectives of the board. With regard to the board of
directors, I recognize that it can be difficult to elect members with the necessary skills and time to
devote to overseeing the bank. While this can be a major challenge, it is obviously important that we
get it right for the overall well-being of the bank.
Conclusion
In closing, I want to emphasize that effective supervision of modern banking organizations will
necessarily entail a closer and more cooperative partnership between industry participants and official
supervisors. The industry's participation in the formulation of a more risk-sensitive capital adequacy
framework is a good example of this kind of constructive interaction. Indeed, the three pillars of the
proposed framework - minimum standards, supervisory review of banks' capital assessment
methodologies, and market discipline - reflect the understanding that regulatory requirements alone are
no longer sufficient to address the growing complexity of banks' activities and the associated risks.
Consistent with this notion is the need for effective corporate governance, which plays an increasingly
important role in a rapidly evolving banking environment.
It is clear to me, as a former commercial banker and now as a supervisor, that only if the industry and
supervisors work together, each meeting our responsibilities and reinforcing the other, will we be able
to successfully manage and supervise a modern financial system. While perspectives may differ from
time to time, our objective is the same - to maintain a strong and vibrant financial system over the long
term.