susan schmidt bies : financial supervision issues remarks by ms susan schmidt bies, member of the board of governors of the us federal reserve system, at the securities industry association annual meeting, boca raton, florida, 5 november 2004. * * * i want to thank you for the invitation to speak at this annual meeting of the securities industry association ( sia ). the financial services industry continues to evolve to meet the challenges posed by mergers, new financial instruments, and changing regulatory frameworks. the federal reserve board, as the umbrella supervisor of financial holding companies, has been working with other regulators and financial institutions to improve the effectiveness and relevance of regulation and supervision in this changing environment. some of the issues that we have been dealing with recently are of mutual concern to both broker - dealers and commercial bankers - albeit they may represent different sides of the coin. others involve reconciling the differing perspectives and regulatory environments of investment firms and commercial banks around similar financial products and activities in the wake of financial conglomeration. today i would like to bring you up - to - date on three such issues, as well as highlight some aspects of the federal reserve ’ s proposed anti - tying guidelines. in all of these areas, i encourage your participation as we work toward new regulatory guidance. accounting for securities the first supervisory issue i would like to discuss involves accounting for investment securities. the recent accounting guidance, the meaning of other - than - temporary impairment and its application to certain investments, or eitf 03 - 1, has raised serious questions about accounting for investments that are held in available - for - sale portfolios. as many of you are aware, when the emerging issues task force ( eitf ) of the financial accounting standards board ( fasb ) came to its consensus earlier this year, it was not intending to dramatically change accounting practices for debt securities. but in early august, the public accounting firms began interpreting the guidance very differently. specifically, if a security was sold from the available - for - sale investment portfolio at a loss, the new interpretation called into question the facts and circumstances that should be used to determine if the remaining portfolio should be viewed as “ other than temporarily impaired, ” and thereby marked down to the lower of cost or market through earnings ( locom ). at the federal reserve, we were concerned about the interpretation since most banks use their available - for - sale portfolio to manage their net interest margin on longer - term, fixed - rate deposits and funding. a loco

securities for banks and other investors, your organizations should be aware of the importance of remaining informed about emerging accounting interpretations that deal with longaccepted practices - not only in the context of providing products and services to your customers, but also in your own bank - like entities that may be affected as investors. regulatory capital issues let me now move on to some accounting issues that relate broadly to the new capital framework for the largest u. s. - based financial institutions, including broker - dealers who wish to have consolidated supervision for purposes of meeting european union requirements. in general, this entails brokerdealer implementation of basel ii capital requirements. as you know, the basel ii effort to revise bank risk - based capital standards is now in its final stages and moving toward implementation. importantly, that effort has adopted an approach to credit risk for instruments held in the banking book that differs from the current capital rules applied to instruments held in the trading book under the 1996 market risk amendment ( mra ) to the basel accord. clearly, the fair valuing or “ marking to market ” of commercial bank trading portfolios and the implied short - term holding periods of such positions factor into the different approaches. we must remember, however, that the mra was adopted at a time when bank trading portfolios looked very different from today. significant growth in structured transactions, collateralized debt obligations, and credit derivatives are just a few examples of the significant developments over the past several years. moreover, the mra was structured with commercial banks in mind and not broker - dealers who, as you know, mark most of their balance sheets to market. also, both banking organizations and investment firms appear to be holding less - liquid instruments at fair value over longer time horizons than has been traditionally associated with the concept of a commercial bank trading account. taken together, these industry and regulatory dynamics suggest that the time may have arrived for supervisors to begin to review the appropriateness of the 1996 mra for commercial bank trading accounts and investment firm fair - valued holdings. in an initial effort to fully identify the types and characteristics of instruments that banks hold in their trading accounts, and that securities firms hold at fair value, a joint subgroup of the international organization of securities commissions ( iosco ) and the basel committee on banking supervision is surveying the industry. this survey seeks to gain a better perspective on the range of techniques financial institutions are developing to more robustly measure the risk these instruments entail. the information acquired in the survey is to