Global Financial Reform: A Regulator's Perspective
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Global Financial Reform:
A Regulator’s Perspective
Remarks by
William J. McDonough
President
Federal Reserve Bank of New York
Chairman
Basel Committee on Banking Supervision
Delivered before the Foreign Policy Association Conference
Global Capital Markets and a New International Financial Architecture
New York, New York
November 17, 1999
1FEDERAL RESERVE BANK OF NEW YORK
1999 ANNUAL REPORT
GLOBAL FINANCIAL REFORM:
A REGULATOR’S PERSPECTIVE
I am delighted to take part this afternoon 1990s in the belief that there was a need to
in the Foreign Policy Association’s conference foster more effective banking supervision
Global Capital Markets and a New International throughout the global financial markets. In
Financial Architecture. It is a special pleasure developing the Core Principles, the Committee
to be here among so many old friends and sought to craft a document that would have the
colleagues. legitimacy, quality, and flexibility to meet the I am convinced that the
needs of bank supervisors around the world.
In my remarks today, I will focus primarily flexibility embodied in
To this end, the Committee made it a key
on issues related to my responsibilities as the Core Principles—
point throughout the various stages of the pro-
Chairman of the Basel Committee on Banking
ject to consult broadly with other supervisors, combined with the
Supervision. First, I would like to give you
particularly those from emerging market valuable substantive
a brief update on the Committee’s efforts to
countries.
implement globally an agreement reached guidance the principles
initially in September 1997 on Core Principles The Core Principles document that resulted provide—is the right
for Effective Banking Supervision. Second, I from this process brings together concisely in
model for achieving
will describe the Committee’s work to pro- one place all of the fundamental elements
mote improvements in risk management, needed to carry out effective banking super- sustainable improvements
including some related lessons drawn from vision—a remarkable achievement in its own in financial market
the near-bankruptcy of Long Term Capital right. Equally important, in my view, the
practices.
Management (LTCM). Third, I will discuss document also balances the desire to set high
the Committee’s proposal for a new capital standards for supervisory practices with a
adequacy framework to replace the 1988 pragmatic recognition that not all countries
Capital Accord and give you some idea of what are in the same stage of financial market
our timetable is. Many of these efforts were development. As such, the Core Principles
initiated prior to the Russian financial collapse document is of particular importance for
in the summer of 1998. There is no doubt, emerging market countries because it estab-
however, that all went into significantly higher lishes a clear set of standards against which
gear thereafter. each country’s current approaches and progress
can be measured.
Let me turn first to updating you on the
status of the Core Principles for Effective I am convinced that the flexibility embod-
Banking Supervision. This is an initiative the ied in the Core Principles—combined with the
Basel Committee embarked on in the mid- valuable substantive guidance the principles
3provide—is the right model for achieving sus- jected meeting is part of the Basel Committee’s
tainable improvements in financial market ongoing commitment to ensure that the Core
practices. The fact that a number of other Principles remain on point and relevant to
international groups have in recent years also banking supervisors worldwide.
developed “core principles” in their respective
I must stress, however, that the most
areas of expertise confirms to me the value of
important efforts to implement the Core
the Basel Committee’s approach.
Principles continue to be the job of the indi-
Today, approximately 120 countries en- vidual countries. Without the support and
dorse the Core Principles. Just last month, I backing of national authorities to follow
am pleased to report, the Basel Committee, in through with the implementation of these
Without the support cooperation with the International Monetary principles, our broader efforts simply cannot
and backing of national Fund and the World Bank, produced a be effective.
follow-up report entitled Core Principles
authorities to follow In this connection, the Basel Committee
Methodology. This follow-up report was initi-
through with the ated in response to requests from a number of has long recognized the need for effective
implementation of {the countries for additional guidance on how to training and seminars for participants in the
interpret and implement the Core Principles. global bank supervision community. Over the
Core Principles}, our years, it has sponsored numerous programs that
What the methodology report does is to
broader efforts simply develop specific criteria to evaluate how the have been beneficial in allowing supervisors
cannot be effective. Core Principles are being implemented in from different countries to share experiences
individual countries. The new methodology and exchange ideas for improved practices.
provides two sets of criteria for each Core Building on its long-standing commitment to
Principle. One set of criteria focuses on issues these outreach efforts, the Basel Committee,
deemed essential for the minimum imple- together with the Bank for International
mentation of the Core Principles; the other Settlements, established the Financial Stability
focuses on those issues deemed to represent Institute in 1998. The Institute currently
“best practice.” conducts leadership training targeted to super-
visors in emerging market countries, facilitates
The International Monetary Fund and the
technical assistance in individual countries,
World Bank currently use this new methodol-
and provides training on a regional basis.
ogy to assess the banking sectors in individual
countries. Looking ahead, the Basel Committee The Basel Committee also plays a key role
plans to bring together sometime next year in the Financial Stability Forum, which was
supervisors from emerging market countries established by the Group of Seven Finance
and representatives from the International Ministers and Governors in early 1999.
Monetary Fund and World Bank to discuss the Through the Forum, the Basel Committee is
lessons learned from this initiative. The pro- able to share its experience in implementing
4FEDERAL RESERVE BANK OF NEW YORK
1999 ANNUAL REPORT
the Core Principles with other organizations highly leveraged institutions. Our goal was to
that have embarked on similar initiatives, such provide a framework for identifying the
as IOSCO, the International Organization of broader issues raised by LTCM, the appropri-
Securities Commissions. More broadly, the ate policy responses for supervisors, and the
Financial Stability Forum is coordinating an key risk management challenges for the
effort to improve awareness of, and accessi- industry going forward.
bility to, training for regulators and supervisors
Under the leadership of Jan Brockmeijer of
worldwide.
the Netherlands Bank, the Basel Committee’s
Turning to the Basel Committee’s efforts report was completed in January 1999. It
to promote improvements in risk manage- revealed a number of deficiencies in banks’ risk
ment, I will comment first on the work related management practices. In particular, it noted
The Basel Committee’s
to highly leveraged institutions. As I have an imbalance among the key elements of the report found that banks
indicated in other settings, the LTCM episode credit risk management process, with too did not obtain sufficient
and the proper supervisory response to it are strong an emphasis on the role of collateral in
financial information to
fundamentally about two things: leverage and protecting against credit loss. This undue
good judgment. Leverage is an important part emphasis caused many banks to neglect other
assess the types and extent
of our financial system, and most of the time critical elements of effective risk management, of risk assumed by large,
it plays a positive role in enhancing market including in-depth credit analyses of counter- highly leveraged
liquidity and ensuring a more efficient alloca- parties, measurement of exposure, and the use
tion of resources. At times, however, financial institutions.
of stress testing.
institutions can go too far in extending credit.
This is where the critical role of good judg- To make sound credit decisions, banks
ment comes in. Let’s not forget that a banker’s need to obtain sufficient information about
two most important decisions are whom to the borrower to provide a comprehensive and
do business with and how far that business timely picture of its risk profile and credit
relationship should be pursued. quality. This is true whether the extension of
credit occurs through a loan or through a
One of the fundamental aims of supervi-
counterparty trading relationship. Yet the Basel
sors is to ensure that banks are using the right
Committee’s report found that banks did not
tools to make these difficult decisions. These
obtain sufficient financial information to assess
tools include risk measurement methods and
the types and extent of risk assumed by large,
risk management techniques that are appro-
highly leveraged institutions. In particular,
priate to the nature of the risks involved.
banks did not obtain the information needed
Following the LTCM episode, the Basel to assess leverage, risk concentrations in par-
Committee put together a working group to ticular markets, or the liquidity risk profile of
focus on the relationship between banks and individual institutions.
5The Basel Committee’s report also con- F establish meaningful measures of
cluded that banks should develop more effec- potential future exposure as well as
tive measures of potential future exposure, credit limits incorporating the results
in recognition of the possibility that credit of stress testing, and
exposures can change over time as market
F monitor exposure on a frequent basis.
conditions fluctuate. The ability to measure
potential future exposure is critical when I am pleased to report that the Basel Com-
dealing with large trading counterparties such mittee’s recommendations on highly leveraged
as highly leveraged institutions, especially in institutions have been reinforced by the recom-
volatile market conditions. Unfortunately, mendations of subsequent efforts, including
A key lesson of the LTCM methods for measuring potential future expo- reports by the President’s Working Group on
sure have not kept pace with the growth and Financial Markets and the Counterparty Risk
episode is that credit and
composition of trading activity. Management Policy Group. There is clearly
market risk cannot be seen widespread agreement between the private
The Basel Committee’s report also showed
as completely distinct, but sector and the official community about the
that banks must develop approaches that better
are liable to interact and steps that firms need to take to address the
account for credit risk under distressed market
weaknesses in risk management identified in
reinforce each other under conditions. A key lesson of the LTCM episode
the LTCM episode. The key remaining issue is
highly stressful conditions. is that credit and market risk cannot be seen as
the strength of the private sector’s resolve to
completely distinct, but are liable to interact
implement these measures.
and reinforce each other under highly stressful
conditions. The use of more rigorous stress test- For its part, the supervisory community
ing, therefore, could have given banks better is carefully monitoring the efforts of banks
warning of the types of exposures they faced. to follow through with the implementation of
improved risk management practices for highly
Together with this January 1999 report, the
leveraged institutions. The Basel Committee
Basel Committee issued a sound practices doc-
intends to prepare a follow-up report on the
ument setting forth guidance for banks and
progress banks are making. In my view, the
supervisors on these topics. For example, these
degree of improvement will signal whether the
sound practices called upon banks to
industry has truly absorbed the lessons of the
F establish clear policies governing their LTCM episode.
involvement with highly leveraged
The approach the Basel Committee has
institutions,
taken with respect to highly leveraged institu-
F adopt credit standards addressing the tions mirrors its efforts in addressing other risk
specific risks associated with these management issues. A primary aim of the
institutions, Committee is to identify and promote prudent
6FEDERAL RESERVE BANK OF NEW YORK
1999 ANNUAL REPORT
risk assessment and control practices by banks. continues to be directly related to poor prac-
By setting out state-of-the-art practices in key tices regarding credit risk management. A key
areas, the Committee provides banks and focus of the report is the need for banking
their supervisors worldwide with the tools to organizations to develop an overall business
measure industry progress toward the goal of strategy for credit risk that incorporates the
effective risk management. tolerance for risk and the level of profitability
the bank expects to achieve from incurring
In recent years, the Basel Committee has
various credit risks. A strategic approach to
engaged in a sustained effort to develop and
credit risk provides a coherent framework for
publicize sound practices in a variety of areas.
practices in such areas as credit-granting crite-
This has included papers on such topics as
ria, credit limits, and credit risk monitoring. In recent years, the Basel
F the management of credit risk,
A second paper, issued by the Basel Committee has engaged
F loan accounting and credit risk Committee in September, addresses the subject in a sustained effort to
disclosure, of corporate governance in banking organiza-
tions. As you know, corporate governance,
develop and publicize
F guidance for managing foreign exchange
settlement risk, especially the role of boards of directors, is of sound practices in a
particular interest in this country. More intense variety of areas.
F enhancing corporate governance in
competition, rapid change, and increased com-
banking organizations,
plexity in many business activities mean that
F a framework for internal control responsible and independent oversight by
systems in banking organizations, boards of directors plays a more crucial role in
F operational risk management, and ensuring that a firm’s business strategy is sound
and its leadership effective.
F risk management for electronic banking
and electronic money activities. I am convinced that the need for strong
corporate governance is equally great in
For anyone interested, the details of these
emerging market countries, where banks and
reports are available on the web site of the Bank
other financial institutions face comparable
for International Settlements.
pressures. The Basel Committee’s September
Before turning to capital adequacy issues, I paper outlines several elements that are critical
would like to highlight some key elements to a sound corporate governance process. These
from two recent papers on sound practice. In elements include the installation of qualified
July, the Basel Committee issued for comment boards of directors with clearly defined
a report on the management of credit risk. responsibilities, the importance of oversight by
This is a particularly important topic since directors and senior management, the need for
the major cause of serious banking problems clear lines of management responsibility and
7accountability, and the effective use of internal capital adequacy. In addition to establishing
and external auditors. minimum capital requirements, the paper
places an increased emphasis on the supervi-
Both the July and September reports pro-
sory review of capital adequacy and the role of
vide a flavor of the Basel Committee’s efforts to
market discipline. We refer to these elements
promote stronger risk management practices
as the “three pillars” of our proposed capital
within the global banking community.
adequacy framework, which together promote
Although these efforts sometimes receive less
safety and soundness. This evolution in the
public attention than our work on capital
Committee’s thinking about capital follows
adequacy, I believe that they play significant from much of our recent work on risk man-
roles in helping to set standards for prudent agement and the surveys we have conducted
In June, the {Basel} risk taking that can be used by banks and their on banks’ disclosure practices.
Committee released a supervisors worldwide.
consultative paper laying In our view, the three pillars to assess capital
Lastly, I would like to update you on the adequacy are mutually reinforcing, each
out our vision for a new Basel Committee’s major effort to revise the addressing the challenge of aligning capital
capital adequacy 1988 Capital Accord. In June, the Committee relative to risk in banking organizations some-
released a consultative paper laying out our what differently. The Committee’s belief is
framework.
vision for a new capital adequacy framework. that by combining the approaches of the three
Our proposed timetable is to seek comments pillars, we can better achieve our overall
from both supervisors and industry partici- objective of ensuring an adequate capital
pants through March 31, 2000, and then to
cushion across the banking system that at the
publish, hopefully by late next year, a compre-
same time recognizes and encourages prudent
hensive set of proposals that is responsive to
risk management.
the comments and industry input we have
received. Let me highlight briefly the three pillars
and provide some perspective on the key
During the comment period, the Committee
challenges that the Committee faces in rela-
and its subgroups are working hard to refine
tion to each. The first pillar has to do with
and further develop a number of the proposals
minimum capital requirements. The 1988
put forth in the consultative document. The
Capital Accord allowed supervisors in the
Committee also continues to consult actively
Group of Ten countries for the first time to use
with banking industry representatives and
a common yardstick for measuring the capital
organizations by holding seminars, inviting
adequacy of banks. While the 1988 Accord
presentations at working meetings, and con-
was a milestone achievement, its simple risk-
ducting surveys on various topics.
weighting scheme has had difficulty incorpo-
The consultative paper represents an evo- rating innovations in the way banks today
lution in the Basel Committee’s approach to manage and mitigate credit risks.
8FEDERAL RESERVE BANK OF NEW YORK
1999 ANNUAL REPORT
More fundamentally, the 1988 Accord Because of the Committee’s desire to pro-
does not adequately differentiate among duce a capital adequacy framework with a
degrees of credit risk. As a result, banks have greater sensitivity to risk, some observers may
had incentives to take on higher risk exposures note that we inevitably introduce a dynamic
within each of the Accord’s broad risk cate- element into our standards. That is, the capital
gories. Banks have also tended to engage in requirements for loans to troubled borrowers
transactions that lower capital requirements will tend to increase at just the point when
without reducing economic risk. The effect of such trouble is becoming apparent. I see an
these developments has been to erode the sig- important positive aspect to such an outcome.
nificance of the Basel ratios as an indicator of
I would argue that the global financial sys-
a financial institution’s capital adequacy, par- The global financial system
tem needs to become better prepared to address
ticularly for the large, internationally active
institutions that were the original targets of the
potential credit problems preemptively, before needs to become better
these problems have time to grow from minor prepared to address
Accord.
disturbances into major disruptions. Imple-
To address these shortcomings in the 1988 menting capital standards that are more
potential credit problems
Accord, the Basel Committee proposes two responsive to the dynamics of risk could help preemptively, before these
primary approaches: 1) a standardized approach move us in this direction and away from a problems have time to grow
that ties risk weightings to external credit mindset that waits too long to address prob-
from minor disturbances
assessments such as credit ratings, and 2) an lems. In particular, the Committee is interested
internal-ratings-based approach that would in hearing views on how we should think about into major disruptions.
begin by mapping internal risk ratings into these issues.
standardized risk weightings but might eventu-
The second pillar in the proposed new
ally evolve into something closer to the full use
capital adequacy framework has to do with the
of credit risk models. Each approach treats the
supervisory review of capital, a critical comple-
trade-off between simplicity and accuracy
ment to minimum capital requirements. The
somewhat differently, and thus one or the
consultative paper calls on supervisors to
other is likely to be relevant to banks with dif-
ensure that each bank has sound internal
ferent levels of sophistication.
processes in place to assess the adequacy of its
Significantly, both proposed approaches capital based on a thorough evaluation of its
attempt to introduce greater risk sensitivity risks and capital structure, thus moving the
into the minimum capital standards. In my Accord beyond a ratio-driven minimum capital
view, it is essential that we move forward in this standard to a comprehensive approach for
fashion in order to enhance the responsiveness assessing capital adequacy. In general, supervi-
of required capital to risk and to address the sors have expected and continue to expect
unfortunate incentive problems that have banks to hold more than the regulatory
evolved from the 1988 Accord. minimum amount of capital. In proposing
9this supervisory review of capital, the Basel assess the strengths and weaknesses of a bank’s
Committee intends to foster a more active risk management and capital allocation pro-
dialogue between banks and their supervisors cesses relative to those of its peers.
with respect to the actual level of capital banks
The Group of Ten supervisors recognize
choose to hold.
the implications that this approach will have
I want to stress, however, that this proposed for supervisory resources. In order to keep
approach to assessing capital adequacy is not pace with industry innovation, it is clear that
intended to replace the judgment and expertise we will have to step up our training and con-
of bank management. Nor is this approach sider effective ways for making the most use
meant to shift ultimate responsibility for the of our limited resources. The Basel Commit-
More extensive disclosure adequacy of bank capital to the supervisors. On tee also recognizes the importance of these
and greater dependence on the contrary, I believe that managers are the issues for countries outside the Group of Ten
market forces complement ones with the most complete understanding of and is working toward providing the training
the risks that their institutions face and it is and other types of support needed to allow
improvements in risk they who must have the primary responsibility these countries and their supervisors to move
management, banking for overseeing these risks. in this direction.
supervision, and minimum The task for supervisors in this framework The third element in the proposed new
capital standards. is to evaluate how well banks are assessing their capital adequacy framework has to do with
own capital needs relative to their risks, includ- market discipline—another critical compo-
ing whether banks are appropriately addressing nent of a safer and more stable financial
the relationship between different types of system. More extensive disclosure and greater
risks. To this end, the Basel Committee is cur- dependence on market forces complement
rently developing guidance to help supervisors improvements in risk management, banking
evaluate internal capital assessments conducted supervision, and minimum capital standards.
by banks. In the event that a bank’s internal Of course, to add value over and above the
capital adequacy process is lacking, supervisors minimum capital standards, improved disclo-
must have the knowledge and authority to take sure must go beyond the simple reporting of
corrective action. minimum capital ratios.
There can be no doubt that implementing When banks disclose timely and accurate
the supervisory review of capital will require information about their capital structure and
considerable insight and flexibility on the part risk exposures, market participants can better
of supervisors because they will have to tailor evaluate risks and act accordingly. The disclo-
their efforts to the unique risk profiles of par- sure of timely and accurate information, in
ticular institutions. At the same time, this turn, is an incentive for banks to ensure that
approach should allow supervisors to draw the market perceives them not only as effec-
on their cross-institutional knowledge as they tively managing their risks, but also as being
10FEDERAL RESERVE BANK OF NEW YORK
1999 ANNUAL REPORT
adequately capitalized. Market reactions to the a large volume of information. More is not
public disclosures of banks can also play an necessarily better.
important signaling role for supervisors in
In the area of disclosure, I should also
assessing the adequacy of a bank’s capital.
mention that my colleague Peter Fisher is
A further reason to encourage disclosure chairing the Multidisciplinary Working Group
beyond the reporting of regulatory capital on Enhanced Disclosure, made up of represen-
ratios is that these ratios have become the pri- tatives from the banking, securities, and insur-
mary focal point for investors and industry ance industries, in a pilot effort to formulate a
analysts. The result has been that bank man- set of public disclosure guidelines that makes
agements have had an incentive to focus solely sense for an increasingly integrated financial
on improvements in these ratios, even when market. The working group will assess the The Basel Committee
the ratios are not fully reflective of risks. More extent to which the pilot data can provide a is seeking to design an
comprehensive disclosure could lessen this meaningful basis for comparing risk manage- expanded set of disclosure
incentive. ment practices as well as the level and types of
guidelines, taking into
With these considerations in mind, the risk across institutions and across countries.
account the proprietary
Basel Committee is seeking to design an The Basel Committee supports this pilot
expanded set of disclosure guidelines, taking information needs
approach. It limits the burden on the banking
into account the proprietary information needs industry and at the same time makes clear that of banks.
of banks. I believe that fuller disclosure for all the private sector has a key role to play in
banks can take us a long way toward effective improving disclosure and enhancing market
market discipline. We also encourage banks to discipline. Firms participating in this program
include in their fuller disclosures information will have the opportunity to shape the en-
specific to their risk profile. deavor and influence the interpretation of its
The timeliness and the quality of disclosure results. Through their participation, these
are important. The frequency of disclosure firms will be sending a clear signal about their
should reflect the nature of the risks involved. willingness to improve market discipline.
Moreover, as transactions that shift risk be-
These have not been easy times for banks.
come more common and complex, disclosing
As a regulator, I cannot help but underscore the
the associated residual exposures takes on added
essential role banks play in the global market-
importance. Such reporting, in turn, requires
place. By intermediating credit between savers
that banks have in place the appropriate sys-
and investors and providing liquidity to the
tems to identify and measure these risks so that
financial sector, banks are the essential link in
the risks can be documented for the market-
well-functioning economies.
place. Finally, as we move toward improved
disclosure, we must keep in mind that the goal Thus, while capital levels and risk manage-
is useful and reliable information—not simply ment policies are without question important,
11they do not take precedence over the responsi- in the demand for cash over the transition
bility of bankers to serve their purpose in a period. Further, the Federal Reserve created a
Schumpeterian world of creative destruction. century date change Special Liquidity Facility
This most fundamental of responsibilities for lending to depository institutions from
involves the use of credit judgment. By this I October 1, 1999, through April 7, 2000.
mean that bankers must not lend to excess Among other things, this facility should help
when times seem good and then lend too little institutions to commit more confidently to
when times appear more difficult. This is an supplying loans to other financial institutions
ongoing obligation of banks and is no less so as and businesses through the rollover period.
we approach the century date change.
Finally, the Federal Reserve Bank of New
I believe it critical that banks approach the York announced a number of measures in early
new year with these thoughts in mind, and I September intended by the Federal Open
call on them to be attentive to providing for Market Committee to promote the smooth
their customers’ reasonable needs. By reason- functioning of money and financing markets
able needs, I have in mind that banks should and to gain greater assurance that we will be
think twice about huge demands based on able to manage banking system reserves during
what seems to be customers’ excessive concern the century date change. The measures include
about Y2K, but grant appropriate credit for the expansion of collateral accepted in repur-
realistic needs, even if this involves somewhat chase transactions, the extension of the
greater use of their own balance sheets than maximum term of the Bank’s repurchase trans-
would usually be the case. actions to ninety days, and the introduction of
a Standby Financing Facility.
To aid in the year-end transition period,
the Federal Reserve System and the Federal The next several weeks will be a challenging
Reserve Bank of New York have announced a period for private and public sector partici-
variety of steps to ensure adequate liquidity in pants alike. By working together in the short
wholesale markets and promote financial term to ensure a smooth transition and over
market stability. We approved last month an the longer term to improve banks’ risk man-
expanded range of acceptable collateral for dis- agement practices and to develop a meaningful
count window and payments system risk pur- international capital adequacy framework, I am
poses. In addition, there are in place a number confident that we can be successful in not only
of measures to ensure that an ample supply of preserving, but also enhancing, our global
cash will be available to meet possible increases financial system as we enter the next century.
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