It is a pleasure to be here and
to address the members of the Institute of International Bankers.
Foreign banks play a critical role in the U.S. financial system,
accounting for nearly one-quarter of total U.S. banking assets
throughout the 1990s. The Federal Reserve has consistently
supported open U.S. markets for foreign banks and has long
recognized the value that you add to our economy and financial
markets. Conferences such as this provide important opportunities
for the banking and supervisory communities to meet with one
another and to share our thoughts and concerns.
In my comments today, I would
like to discuss the apparent motivation for managers to create
global financial institutions, which provides the background for a
convergence of regulatory standards around the world. I would also
like to mention briefly the approach that the Federal Reserve is
taking with respect to foreign banks. Finally, I would like to
focus on the emerging global regulatory standards, mainly the
efforts of the Basel Committee on Banking Supervision to revise
risk-based capital standards.
Global Consolidation of
Financial Institutions
The need for sound and consistent policies and procedures
throughout the world has become more important as our financial
markets and financial institutions have become larger, more
complex, and more tightly integrated. If anyone needs proof of
that statement, the spread of the Asian crisis during the course
of 1997 and 1998 stands as the most obvious example of the growing
integration of financial markets. Informed researchers would argue
that the global consolidation of financial institutions appears to
be driven by several factors. Originally, globalization probably
reflected the desire of banks to serve their domestic customers as
those customers themselves expanded overseas. This was probably a
defensive measure designed to retain customers and preclude others
from making inroads into longstanding customer relationships. For
other financial institutions, the motivation for overseas
expansion may well have been to fully leverage perceived
comparative advantages in important business lines, such as
custody, that were characterized by high fixed cost and economies
of scale. A related motivation might have been to take advantage
of cultural affinity, which itself is another form of comparative
advantage. The strong presence of Spanish financial institutions
in Latin America may be the prime example of this motivation.
Finally, many institutions may have expanded to meet ambitious
aspirations for growth that comparatively small local markets
might not accommodate. Certainly, one might argue that the global
reach of major Dutch and Swiss institutions reflects this
motivation, at least in part.
Importantly, one must ask if
global institutions are more successful than their home-bound
competitors. At least one private-sector study, from a major
consulting firm, suggests that during the ten-year period ending
December 31, 1996, most of the global financial services companies
did not achieve significantly superior returns to shareholders.
Nor did they appear to achieve superior revenue growth. I am sure
that there will be other studies that attempt to determine the
effect of global consolidation on the financial results of the
firms involved.
In any event, regardless of the
presence or absence of financial success, the trend toward a more
global financial industry will continue. Such market forces will
provide a continuing impetus for continued cooperation and
coordination among bank supervisors worldwide. Indeed, the forces
for cooperation will only grow as these trends become more
pronounced.
The Gramm-Leach-Bliley Act
Issues related to the international supervision and regulation of
banks come at a time when we in the United States face new
challenges in implementing financial reform and the provisions of
the Gramm-Leach-Bliley Act. That act has the potential, and indeed
the intention, to change substantially the structure, activities,
and supervision of financial institutions in this country. Many of
the foreign banks represented here today operate as universal
banks outside the United States and, like many U.S. banks, you
have been frustrated by the outmoded restrictions on your banking
activities in our markets. After much debate, the U.S. Congress
enacted legislation that permits banks operating in the United
States to expand their activities within a legal and supervisory
framework intended to preserve their safety and soundness.
As you well know, the Federal
Reserve Board recently issued for public comment an interim
amendment to Regulation Y setting forth the procedures for banking
organizations to elect to become financial holding companies and
avail themselves of the broader powers authorized under the act.
In according financial holding company status to foreign banks,
the Congress instructed the Board to apply capital and managerial
standards comparable to those pertaining to U.S. banking
organizations, giving due regard to the principles of national
treatment and equality of competitive opportunity. The rule
applies the U.S. bank risk-based capital standards of 6 percent
Tier 1 capital and 10 percent total capital to foreign banks
wishing to become financial holding companies. It also applies the
U.S. leverage ratio to foreign banks, but at the lower holding
company level of 3 percent, instead of the 5 percent ratio
required of U.S. banks.
To consider differences in
banking and accounting practices in many foreign countries, the
Board also will assess the capital and management of foreign banks
case by case. This assessment will take into account, when
appropriate, a number of factors such as the bank's composition of
capital, accounting standards, long-term debt ratings, reliance on
government support to meet capital requirements, and the extent to
which the bank is subject to comprehensive, consolidated
supervision. The intent of this approach is to provide the
flexibility necessary to take into account all relevant factors in
a way that will be equitable to all banks, foreign and domestic.
We understand that there is concern that this procedure will be
subject to delays, resulting in disadvantages to foreign banks.
Let me assure you that we fully intend to deal with submissions
from foreign banks expeditiously and in the same time frames that
are provided for the review of submissions by U.S. companies. If
different procedures will allow us to meet the statutory
requirements on comparability, we are very open to considering
them.
The Board recognizes that this
interim rule is of great interest to foreign banks and that it
raises complex issues--in particular, how to achieve comparability
as required by the law while still respecting the home country
supervisory framework. This balance is difficult to achieve, and
the Board intends to give careful consideration to the comments it
receives in response to the interim rule. The Board is committed
to implementing this new law in a manner that is equitable and
fair to all institutions and that ensures a sound and stable
framework for the evolution of financial services in the United
States.
Basel Committee on Banking
Supervision
In supervising financial holding companies, the Federal Reserve
will need to consider not only the Gramm-Leach-Bliley Act but also
the policies and actions of other agencies in this country and
abroad. Fortunately, we have been working together for several
years to deal with issues arising from activities of financial
conglomerates. I think that much of the experience we have gained
through our participation in groups such as the Basel Committee on
Banking Supervision, the Joint Forum, and the Financial Stability
Forum will help us meet the challenges ahead.
Because time is brief, I will
focus the balance of my remarks on the work of the Basel
Committee. The Federal Reserve has been actively involved in this
committee since its inception in the mid-1970s, and the Basel
Committee continues to take the lead in coordinating banking
supervisory policies and practices globally. Although
representatives from the G-10 countries and Luxembourg do the work
of the committee, it recognizes that supervisors in most of the
non-G-10 countries typically adopt the policies and principles
that the committee adopts. As a result, the committee has sought
to incorporate the views of supervisors throughout the world. A
non-G-10 working group, for example, is participating in the
current revisions to the Capital Accord.
As I know you are all aware, the
Basel Committee is devoting a tremendous amount of time and
resources to the effort to develop a new capital adequacy
framework that is more sensitive to the level of underlying
economic risk. Indeed, comments are due soon on a consultative
paper issued last year on this topic. Feedback from the industry
is important to the Basel Committee, and I hope that many of you
will be communicating your ideas and reactions to the Bank for
International Settlements.
Capital requirements are an
essential supervisory tool for fostering the safety and soundness
of banks. The 1988 Basel Capital Accord was a major achievement in
establishing a uniform standard for internationally active banks.
In the years since, the committee has continued to develop and
refine the standard in an effort to keep pace with banking
practices and to maintain adequate levels of bank capital
throughout the world.
Many have asked why the Basel
Committee is revising the accord at this time. There has been
recognition from the start that the 1988 accord was rather crude
and imperfect in many respects. Although that accord incorporates
some differentiation in credit risk, it is limited. Moreover, the
accord does not explicitly address interest rate risk, operational
risk, or other risks that can be substantial at some banks.
Consequently, some countries, including the United States, have
put in place supplementary requirements-such as target ratios
above the minimum levels-to help mitigate the accord's
shortcomings. For example, as a further prudential measure, the
United States decided to apply a separate leverage constraint to
provide some limit to leverage, regardless of what the
risk-weighted Basel approach might allow.
Beyond these initial and
inherent imperfections of the accord, simply the dramatic
innovations over the past decade in financial markets and in the
ways in which banks manage and mitigate credit risk have driven
the need for change. The committee has been concerned particularly
about the incentives that the accord gives banks to take on
higher-risk, higher-reward transactions, and to engage in
regulatory capital arbitrage. Efforts to make the standard more
sensitive to underlying risk should greatly reduce these
incentives.
Basel Committee Consultative
Paper
Last year's consultative paper set out a new paradigm for judging
capital adequacy based on a set of three so-called pillars. Pillar
I is sound minimum capital standards or, in essence, the existing
Accord with improvements. Pillar II is supervisory oversight of
capital adequacy at individual banks, and pillar III is market
discipline supported by adequate public disclosures by banks.
These three pillars represent an evolution in the Basel
Committee's approach to capital adequacy and should be mutually
reinforcing. The addition of pillars II and III acknowledges the
importance of ongoing review by supervisors of the capital
adequacy at individual banks and the critical role of market
discipline in controlling the risk-taking of banks.
The committee's revisions to
pillar I are aimed at developing minimum capital standards that
more accurately distinguish degrees of credit risk and that are
appropriate for banks of varying levels of sophistication. In its
consultative document issued last June, the committee set out two
possible approaches: a standardized approach that would tie
capital requirements to external credit assessments, such as
credit ratings, and another approach that would be based on a
bank's own internal ratings. The latter would derive a capital
requirement from bank estimates of default probabilities and from
estimated losses-given-default on individual exposures. Using such
estimates would help greatly in making capital requirements more
sensitive to different levels of risk but would also introduce
more subjectivity and a lack of transparency into the process.
Therefore, we may need to limit or constrain certain measures. How
to validate the estimates will also be an issue, especially
considering that banks, themselves, often have little historical
data on which to base key assumptions and calculations.
Comparability and competitive equity among banks and national
banking systems will be important factors in the debate.
Nevertheless, the two-pronged
approach of offering both a simplified and a more complex method
seems both necessary and reasonable in order to accommodate all
types of banks. Even then, however, we must recognize that any
standard will continue to evolve. Although I believe that an
internal ratings-based approach would provide an important step
forward, its results would still likely differ from those of a
bank's own economic capital allocation models. Questions about the
correlation of risks among different asset groups and about how
and whether to consider them in a regulatory capital standard are
still unresolved and go to the heart of full credit risk models.
Beyond credit risk is the highly
complex matter of operating risk and other risks that are not
explicitly dealt with in the accord. In the past, of course, the
overt charge for credit risk has carried the full load of these
other risks, but that has begun to change. Both the Basel
Supervisors Committee and the international banking community need
to address these topics more directly and more satisfactorily.
Regardless of what regulators and supervisors do, you as bank
managers must fully recognize and control your risks. As you make
greater progress, so can regulators.
In the past, relatively rough
rules-of-thumb and traditional practices sufficed in supervising
and managing banks. But just as derivatives have allowed you to
unbundle risks and to price and structure financial products with
more precision, similar technologies and innovations are requiring
more precision in almost everything else you do. And also
everything we do as bank supervisors. Opportunities for arbitrage
within financial markets and capital regulations are easily found.
What you do within the industry and what we do as bank supervisors
must be more closely connected in all respects to the underlying
economics. Meeting that challenge will keep all of us on our toes.
Recognizing that supervisors
need to relate capital requirements of individual banks more
closely to their unique risk profiles, the Basel Committee's
second pillar--the supervisory review of capital--emphasizes
principles such as these:
I believe it is essential to
have effective supervisory oversight and assessment of individual
bank capital as a complement to meeting regulatory capital
requirements. This does not mean, however, that supervisors have
ultimate responsibility for determining the adequate level of
capital at each bank nor that supervisory judgment should replace
that of bank management. Rather an active dialogue should take
place between bank management and supervisors with regard to the
optimum levels of capital. Pillar II thus moves the accord beyond
a simple ratio-based standard to a more comprehensive approach for
assessing the adequacy of capital levels.
The supervisory review of
capital called for in pillar II obviously will have resource
implications for supervisors around the world and may require
significant changes in supervisory cultures and techniques in many
countries, both G-10 and non-G-10. The committee will need to
develop guidance for bank supervisors to use when evaluating the
adequacy of internal capital assessment processes. A residual
benefit of such evaluations will be that supervisors will more
easily stay current with evolving industry practices related to
risk management and will better understand the risks that
individual banks face.
The third element of the
proposed new capital framework--pillar III--relates to market
discipline, which I believe all supervisors recognize as a
critical complement to their supervisory oversight process. When
banks disclose timely and accurate information about their capital
structure and risk exposures, market participants can better
evaluate their own risks in dealing with such institutions.
Greater market discipline, in turn, gives banks more incentive to
manage their risks effectively and to remain adequately
capitalized.
Recognizing that current
disclosure practices in some countries are relatively weak, the
Basel Committee under this pillar is working on guidelines that
would make banking risks more transparent. The goal is to protect
legitimate proprietary information, while promoting more
consistent disclosure among nations. Adequate disclosure becomes
even more important as we base regulatory capital requirements on
internal risk measures of banks. Clearly, more information, by
itself, is not always better. Working with the industry, we need
to decide which specific elements are needed to do the job.
Indeed, an ongoing partnership between banks and supervisors is
crucial to the success of any regulatory capital standard and to
the success of the supervisory process overall. It is in
everyone's interest that we succeed in this effort and that the
international financial system remain sound.
Other Basel Committee
Initiatives
Although the Basel Committee may be best known for its work on
capital standards, its efforts extend well beyond that--as
suggested by the two other pillars. Its development of the Core
Principles for Effective Banking Supervision in 1997 is
particularly noteworthy. These twenty-five principles cover a
broad range of supervisory issues involving licensing and
supervising banks and enforcing supervisory judgments. By setting
reasonable thresholds for standards that banking supervisors in
all countries should achieve, the committee has substantially
helped to promote financial stability worldwide. Of course, the
challenge now is to help all countries meet these core principles,
despite the limited expertise and resources some may have.
Fortunately, the International Monetary Fund and World Bank are
working with the committee and can be of significant help.
The securities and insurance
supervisors have taken similar steps in developing supervisory
principles of their own that should contribute to stronger
supervisory regimes worldwide and provide a framework for further
harmonization with banking standards, when appropriate.
Conclusion
In closing, I see no shortage of difficult challenges facing
financial institution supervisors in the period ahead. Clearly,
supervisors of the various sectors of the financial
industry--banking, insurance, and securities--will continue to be
confronted with rapid and dramatic changes in banking and
financial markets. Supervisors will need to react to technological
innovations, expansion of financial institutions into new and
increasingly more complex activities, and ongoing consolidation
within the industry worldwide. A rigorous, coordinated supervisory
approach will be necessary to counterbalance the pressures of an
increasingly dynamic and competitive marketplace. I am confident
that by working together and with the financial industry
supervisors we can meet the challenge. I want to assure you that,
as central bankers, we at the Federal Reserve have strong
interests in maintaining efficient, well-managed, and responsible
financial institutions.
I wish you all well in the years
ahead. Thank you for your attention.