Ms. Phillips focuses on four themes underlying sound international banking
supervision Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the
US Federal Reserve System, before the Conference on Coping with Financial Crisis in
Developing and Transition Countries: Regulatory and Supervisory Challenges in a New Era of
Global Finance, Forum on Debt and Development held at the Netherlands Bank in Amsterdam
on 17/3/98.
It is a pleasure to be here to address this international conference of fellow
banking supervisors and other distinguished international participants. Conferences like this
one are important forums for discussing current issues in international banking supervision
among the supervisors, bankers, and other financial industry participants of many nations. Such
communication has become critical as the financial operations of the banks we supervise
become more global, complex, fast paced, and interwoven. I would like to thank the Forum on
Debt and Development and other co-sponsors for organizing this conference, which I hope will
help us build essential bridges among banking supervisors and open new channels of
communication internationally at all levels.
I would like to focus my remarks today on four fundamental themes underlying
the 1997 Basle Supervisors Committee's Core Principles of Effective Banking Supervision. As
I discuss each theme, I will naturally draw on our experience in the United States, while
making a few observations about the applicability to the current Asian banking situation.
• The first theme is the need to focus supervisory efforts on the specific
risk profile of individual institutions.
• My second theme is the need for sound accounting and disclosure
systems to provide sufficient transparency to allow the financial markets
and supervisory agencies to evaluate institutions' financial conditions.
•
My third theme is the need for adequate capital and the challenges we
face in keeping capital standards current.
•
Finally, we must recognize the need for international banking
supervisors to work closely and cooperatively together to achieve
effective coordinated supervision of global banks and other financial
firms.
I. Risk-Focused Supervisory Approach
One of the goals of banking supervisors is to help identify and address weak
banking practices early so that small or emerging problems can be addressed before they
become large and costly. To do that in today's global fast-paced markets, and in an
environment in which technology and financial innovation can lead to rapid change, the
Federal Reserve is pursuing a risk-focused supervisory approach. Such supervision plays a
critical role in helping us to achieve our responsibilities of:
• working to ensure the safe and sound operation of the banking
organizations that we supervise,
• promoting an efficient and effective financial system that finances
economic growth, and
• ensuring that financial institutions do not become a source of systemic
risk, threat to the payment system, or burden to taxpayers by making
them absorb losses arising from inappropriate extension of the federal
safety net.
The Federal Reserve has undertaken its new risk-focused examination approach
to respond to the dramatic changes that are occurring in the banking and financial services
business, including tremendous advancement in technology and securitization, the breakdown
of traditional product lines, the expansion of banks' global operations in the world's financial
markets, and the development of new risk management systems. Furthermore, developments in
technology and financial products, combined with the increased depth and liquidity of domestic
and global financial markets, have enabled banks to change their risk profiles faster than ever
before. A key goal of the Federal Reserve's risk-focused approach is to enable banks to
compete effectively in this dynamic financial services sector, while focusing examiners on
banks' ability and willingness to deal effectively with their own risk exposures rather than on
standardized examination checklists.
US banking supervisors in the past focused primarily on validating bank balance
sheets, particularly the value of loan portfolios, as of a specific point in time. Losses on banks'
loan portfolios historically have been the principal source of their financial problems.
Concentrating on the quality of banks' loans and the adequacy of their reserves was, and
continues to be, essential to sound banking supervision. As part of the examination process,
examiners reviewed the soundness of management practices, internal controls, and internal
audit activities, but that review was not the examination's primary focus. The Federal
Reserve's adoption of a risk-focused approach, however, reflects its view that examiners
should target their work on individual banks' specific risk profiles, including the traditional
examination of loan quality and reserves.
This need for fundamental change in the traditional approaches of bankers and
supervisors became evident in reviewing the lessons learned from the turmoil, stress, and
change in the US banking system over the past decade. Ten years ago, many of the United
States' largest banks announced huge loan loss provisions on doubtful loans to developing
countries, while many banks were also struggling under the weight of loans to the energy,
agriculture and commercial real estate sectors. By the end of the 1980's, more than 200 banks
were failing annually. There were more than 1,000 banks on the problem list of the Federal
Deposit Insurance Corporation, which is the US banking agency that insures bank deposits and
serves as receiver for failed banks. This period includes the costly crisis of the US savings and
loan industry -- which is composed of institutions chartered to make home loans available to
the American public.
In response to these systemic developments, bankers and supervisors each
changed their fundamental ways of operating and managing risks. For their part, bankers
recognized the need to rebuild their capital and reserves; strengthen their internal controls;
diversify their risks; and improve internal risk management systems. The Federal Reserve, in
turn, responded to these changes by adopting its risk-focused examination system tailored to
assessing the quality of individual banks' internal processes and risk management systems. The
need for this approach is illustrated by the failure of several high-profile international banking
organizations that did not have adequate internal control and risk management systems.
Adopting a risk-focused approach improves the examination process by
targeting examinations more directly on specific institutions' problems. However, it also makes
such examinations more challenging for examiners because they must be knowledgeable about
each bank's business activities, risk profiles, and risk management systems. Furthermore, we
are trying to make these examinations more efficient for examiners and bankers by employing
valid statistical sampling methods, which will free examiner time to devote to banks' specific
risk exposures.
In addition, banking supervisors need to assess the integrity and independence of
a bank's decision-making processes, giving special attention to any conflicts of interest or
insider influence that could distort this process. The Basle Committee's Core Principles for
Effective Banking Supervision address this point by recognizing the need for effective
measures to control directed lending and transactions with affiliates that are not on an
arm's-length basis. Specifically, the Core Principles state that, to prevent abuses arising from
connected lending, banking supervisors should require that any loans banks make to related
companies and individuals be on an arm's-length basis; that such extensions of credit be
effectively monitored; and that other appropriate steps are taken to control or mitigate the risks.
For example, the Federal Reserve's Regulation O, whose application was expanded to directors
in the early 1990s, is aimed at making sure that any loans a bank makes to officers or directors
are on the same terms that are available to the general public.
Finally, the Federal Reserve places great reliance on on-site examinations to
make the presence of supervisors tangible to bankers and to facilitate the review of records and
documents that are essential to assessing a bank's financial condition. Such on-site
examinations also permit examiners to observe whether bank policies are being followed in
practice, or, alternatively, whether they only exist on paper. Although I recognize that many
other countries do not conduct on-site examinations for legal and other reasons, the Federal
Reserve concurs with the position taken by the Basle Committee's Core Principles that it is
important for supervisors to perform some on-site supervision.
II. Need for Sound Accounting and Financial Transparency
The Federal Reserve believes that sound accounting and transparent financial
information is a fundamental pillar of a strong banking -- and, indeed, financial -- system.
Transparency is essential for the market to be able to make decisions on an informed basis. The
arms-length negotiations of informed investors and issuing banks provide the strongest market
basis for the issuance and pricing of equity and debt securities, as well as loans. Banking
supervisors should strongly advocate transparency to aid effective supervision and market
discipline. Indeed, they can encourage the process directly through appropriate regulatory
reporting requirements and even making all or part of those reports public.
It is important for governments to allow market forces to reward prudent
behavior and penalize excessive risk-taking. Sound, well-managed firms can benefit if better
disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk
profiles. Inadequate financial disclosure, on the other hand, could penalize well-managed
firms, or even countries, if market participants do not trust their ability to assess firms' or
countries' fundamental financial strength.
Regulatory structures that overly protect banks from market forces, or that allow
lax accounting and disclosure to disguise firms' financial problems, remove market discipline
on banks and permit them to operate less efficiently. Deposit insurance systems and the public
safety net are examples of regulatory interference with market forces, despite their public
benefit. They create a moral hazard by allowing institutions to take on what might be excessive
risk without proportional fear that their ability to raise funds at favorable rates will be
impaired. This is illustrated by the costly US savings and loan crisis of the 1980s. Lax
accounting and capital standards allowed economically insolvent institutions to continue
operating and attracting insured deposits at attractive rates because the deposits were
government insured. This, in turn, delayed government and public recognition of the scope of
the problem and tremendously increased the cost of its resolution to the deposit insurance
system and the American taxpayer.
To be credible to global investors, accounting standards should be established by
independent professional organizations and enforced by a combination of market discipline and
national oversight authorities. Particular to banking and the credibility of banks' financial
statements is the establishment of prudent levels of reserves. Investors must be confident that
banks are establishing sufficient levels of reserves and recognizing loan impairment in a timely
fashion. Compliance with sound accounting, disclosure, and reserving standards not only
protects safety and soundness, but also gives the world's investment community confidence in
its analysis of risk exposure from investing in various countries and companies. The absence of
such confidence, on the other hand, may lead investors to overreact to adverse financial events
in such countries by ceasing investment, immediately withdrawing current investment funds
and demanding a high return for any remaining or renegotiated investment in such countries.
Today's technology and global financial markets enable investors to take these actions very
quickly with dramatic consequences, as has recently happened in some Asian countries.
Another issue related to the efficient operation of market forces is that
government intervention in the credit and investment decisions of banks distorts market
discipline and pricing. Such programs frequently cause banks to make less than arm's-length
investments in, and loans to, non-economic government-affiliated projects or to individuals
associated with such projects. Once these loans are made, it is difficult for national supervisors
to demand that banks apply prudent reserve and charge-off policies, let alone foreclose on such
loans. In addressing governmental interference with market forces at their meeting in London
in February, representatives of the G-7 countries unanimously supported the International
Monetary Fund's requirement that countries receiving IMF funds make structural reforms to
reduce inappropriate government interference in the market economy. The message that
governments should heed is that, ultimately, market forces will come to bear with severe
results if firms or nations are artificially protected from market forces.
III. Sound Capital as a Risk-Absorbing Buffer
My third major theme today -- the importance of adequate capital -- has drawn
much attention in the past decade as a result of the Basle Accord. The idea is pretty simple: if
we want banks to be prudent in their risk-taking, there is no substitute for requiring banks'
owners to have their own money at risk. With that requirement, supervisory interests and
banks' private interests are more closely aligned and banks have fewer incentives to take
excessive risks. When banks' managers and directors assess the riskiness and profitability of
prospective business opportunities, they will weigh heavily the potential effect of new business
activities on their banks' capital positions.
Capital must be sufficient, but "How much capital is enough?" The answer is
linked, of course, to the level of risk that an institution takes. Institutions that aggressively
pursue risky business strategies clearly need a stronger capital base than those with more
conservative objectives and products.
While a fairly simple approach, the Basle risk-based capital framework has
proven to be a balanced risk-focused framework for setting minimum capital standards for
thousands of banks of all sizes worldwide. It is important, though, that banks not misuse this
minimum prudential standard by substituting it for more rigorous internal evaluations of capital
adequacy suitable for their own risk exposure and the sophistication of their financial
strategies. For example, US supervisors support the development by a limited number of
sophisticated banks of advanced credit risk models for assessing such institutions' internal
capital needs to keep their probability of default within their established parameters. Such
systems represent significant advances in developing systems to tailor banks' assessments of
their capital needs to their credit risk exposure. On the other hand, the cost and complexity of
such systems raises issues about their current feasibility as part of the uniform capital measure
for all institutions. In any case, banks must rely on their own internal capital assessment
systems targeted to their risk profiles and financial sophistication, as well as complying with
the necessarily broadbrush, uniform capital standard established under the Basle Accord.
We must look constantly for better ways to design regulatory capital standards
and to promote adequate risk measurement in banks. On this note, the US Federal Financial
Institutions Examination Council held a conference for bankers and supervisors last December
to consider a myriad of views on ways that capital regulation should be modified to address
changes in banking and risk management. The New York Clearing House Association just
completed a pilot study of the pre-commitment approach to capital requirements for market
risk. The Federal Reserve Bank of New York also recently organized a conference, in
conjunction with the Bank of England, Bank of Japan, and the Federal Reserve Board, for the
exchange of economic papers on developments in risk assessment and management, as well as
on how such advances should be incorporated into the international capital framework.
Although considerable progress has been made in amending the Basle standards in such areas
as market risk, there will no doubt be additional changes as new tools are developed to address
credit risk differentials, interest rate risk and, perhaps even, operational and legal risk. Indeed,
capital standards should be thought of as an evolving process.
IV. Coordinated International Supervision
We all recognize the need to achieve coordinated international banking
supervision based on cooperation and strong working relationships between home country and
host country supervisors. New challenges in attaining this goal are presented by the advent of
new technologies, the geographic expansion of banking activities, and the globalization of
financial markets. We should work together, relying on the leadership of home country
supervisors, to analyze banks on a consolidated global basis as the financial market does. Home
country supervisors need sufficient global information and international cooperation to perform
their supervisory responsibilities, while enabling host country supervisors to oversee the
activities of international banks in their countries.
A key issue arising for all of us, both internationally and domestically, is the
growing prevalence in world markets of financial conglomerates -- which blend banking,
insurance, securities, and other financial activities in a single diversified global entity.
Universal banking in some nations' financial firms has long combined banking and securities
activities, and to some extent insurance powers, in a single entity. Such financial
conglomerates, which are growing in number and size, engage simultaneously in a myriad of
businesses and seek to integrate those businesses to cross market their varied products. This
presents a significant supervisory challenge because most of our legal frameworks use separate
and different approaches for each traditional segment of the financial industry.
The challenge of achieving coordinated international supervision of such
conglomerates is addressed in the consultative documents, "Supervision of Financial
Conglomerates," developed by the Joint Forum on Financial Conglomerates. These working
papers were announced on February 16th by the Basle Committee on Banking Supervision, the
International Organization of Securities Commissions (IOSCO), and the International
Association of Insurance Supervisors (IAIS). The Joint Forum, which was formed to help
coordinate the international and inter-industry supervision of financial conglomerates,
requested comment by July on these papers. The documents make concrete recommendations
for steps that supervisors in each of the securities, insurance, and banking sectors can take to
enhance supervision of the group-wide risk exposures of these global and inter-industry
conglomerates. The documents also stress the need to enhance cooperation and information
exchange among the supervisors in each country and industry segment.
Implementing these recommendations may necessitate changing the legal
framework of our financial oversight frameworks, but major changes in our financial
institutions and markets demand changes in the supervisory frameworks of our countries. The
United States is no exception.
Conclusion
In closing, I want to reiterate that banking supervisors must work together to
achieve effective consolidated supervision of global banks under a shared set of supervisory
principles, such as the Basle Committee's Core Principles. Furthermore, I believe that the best
way to implement coordinated global supervision is to focus on the four themes that I have
highlighted today -- the benefits of risk-focused supervision, the value of sound accounting and
disclosure, the need for adequate capital, and the importance of international supervisory
coordination.
I appreciate having the opportunity to meet with you today to discuss key
supervisory issues. I look forward to our continuing joint supervisory efforts toward
coordinated international bank supervision.