Supervising LCBOs: Adapting to
Change
Conference themes, rhetoric, and
commentary have emphasized the nature of dramatic change in the
banking industry for so long that it has become one of the cliches
that dominate our professional lives. The reality of change in
banking--significant and dramatic change--has become, well,
humdrum. It has, in fact, become so well understood and so real
that the Congress has finally enacted financial modernization
legislation. This is not a cheap shot. The Gramm-Leach-Bliley Act
was a massive and complicated effort to make the legal structure
consistent with the new reality while accommodating the myriad of
new and old interests affected by the economic and legislative
changes. Arguably, the legislation, to a considerable degree,
validated in law changes that had already occurred--or were soon
to occur--in the marketplace with the aid both of loopholes and of
regulatory actions. Nevertheless, it is worth emphasizing that
structural and other efficiency gains brought about by statutory
revision are important in and of themselves.
The supervisory response to
change--the real theme, I hope, of this conference--is quite
another matter. That is to say, the official response of the
banking agencies to the changes in banking is, I think,
incomplete. To be sure, we have made some real progress with
risk-focused examinations that recognize the reality that
effective risk-management systems are critical to the safe
operation of a modern bank. Similarly, the use of models to
determine capital for market risk on traded securities and
derivative positions is another genuine step forward.
But, despite these advances, our
capital rules have been undermined by the state of the art. The
one-size-fits-all risk weight for credit risk on commercial loans
has induced creative ways to arbitrage whenever regulatory capital
exceeds economic capital. At the same time, banks have taken
advantage of being undercharged for capital for loans with
above-average risk. The result has been a greater emphasis by
banks on unproductive capital arbitrage schemes and bank capital
ratios that are significantly less relevant and informative than
intended. Indeed, as banks become more adept at internal risk
classifications, their incentive to arbitrage economic and
regulatory capital can only increase, and regulatory capital will
carry less and less meaning.
In addition, the growing scale
and complexity of our largest banking organizations--and, I might
add, not only ours but also those of many other nations--raises as
never before the potential for systemic risk from a significant
disruption in, let alone failure of, one of these institutions. We
seem, in this regard, to face the unattractive options of exposing
our economies to additional risk in order to obtain financial
efficiencies and market choices or of imposing more regulation
with both its attendant moral hazard and inefficiencies.
Bank supervisors have been
trying to respond to this new reality, to adapt to change as it
were. The response is taking longer than we wish. But it is
important to get our response as right as we can because so much
is at stake.
At the Fed, we are working
through three major channels: through the evolution of the Federal
Reserve System's supervisory practices in cooperation with the
other banking agencies; through the Basel Committee on Banking
Supervision, where we meet with officials from other G10
countries; and through work in a System group called the F-6,
which I chair. Much of the effort in each case is directed at what
we call the Large Complex Banking Organizations or LCBOs. By
talking of F-6s and LCBOs, I'm about to share with you some of the
secrets of the temple. You, too, will soon be able to talk the
talk of the central banker by spicing your conversation with the
same catchwords.
Before I discuss the evolution
in supervisory practice in the Federal Reserve System and other
agencies, let me briefly note the highlights of our work with the
Basel supervisor's committee, for this work sets the stage for
some of the issues I want to discuss with you. For those of you
interested in the economics of bank supervision, the research of
Dave Jones and John Mingo on capital arbitrage, Mark Carey and
Bill Treacy on internal risk classifications, and Mark Flannery
and Charlie Calomiris on market discipline contributed importantly
to the work on improving the international accord in Basel.
As you know, the evolving
consensus of the Basel supervisors is to base a new accord on the
so-called three pillars of capital, supervision, and market
discipline. More specifically, the capital pillar--at least for
larger banks, as I will discuss momentarily--is to be designed so
as to link regulatory capital more tightly to the same economic
capital that banks use for their own internal management. Large
banks already have been directed by the Fed to create internal
risk classification systems for such purposes, and cutting-edge
banks have made substantial progress. We fully anticipate that
within the next decade, or less, these systems will evolve into
full internal risk models that could be used to measure market and
credit risks throughout large banks.
Bankers do not want their
institutions to fail and--with exception of when failure may be
close at hand--never plan to take excessive risk with inadequate
capital. They will, no doubt, strive on their own to establish
strong and meaningful internal risk classification systems and
internal risk models. But the second pillar--supervision--is to be
used in a "trust, but verify" mode. That is, a major
role of supervision will be to independently test and compare
systems and models to best practices. This is already occurring at
the Fed and the Office of the Comptroller of the Currency (OCC).
Although supervisory reviews of
risk management systems will become even more important in the
years ahead, they are not enough by themselves. As large banking
institutions become increasingly complex--and fund themselves more
from non-insured sources--market discipline and its prerequisite,
public disclosure, must play a greater role. Indeed, increased
transparency and market discipline can also help substantially to
address concerns about increased systemic risk associated with
ever-larger institutions and to avoid the potentially greater
moral hazard associated with more-intrusive supervision and
regulation.
The edifice that these pillars
are to support is not designed to cover all banks in the United
States. For most, the existing system works just fine with only
minor modifications and probably will continue to do so for the
foreseeable future. Rather, the edifice covers the large, complex
banking organizations that engage in capital arbitrage and often
operate at the edge of the envelope in risk-return tradeoffs and
in the creation of new instruments and strategies. Thus, the U.S.
banking agencies have been strong supporters of
"bifurcation" in the Basel deliberations--central
bankese for having separate policy applications for large banks
and for other banks.
Indeed, the OCC has had a large
bank program for some time, and the Federal Reserve has
established a separate supervisory arrangement for LCBOs. The Fed
has designated about thirty entities--accounting for about 60
percent of total U.S. bank assets--as LCBOs. The number and
distribution of these organizations will no doubt change over
time; one-third, by the way, are now foreign owned, a fact that
vividly highlights the globalization of banking. Each LCBO has a
designated team of Federal Reserve supervisors whose job is to
thoroughly understand the organization's business strategy,
management structure, key policies, and risk control systems. Each
team is led by a senior examiner--designated a central point of
contact, or CPC. The CPC and his or her team of examiners draw on
specialists in risk management, payments, credit- and market-risk
modeling, information technology, and other technical areas.
I've already mentioned the
increasing emphasis of the OCC and the Fed on the largest banking
organizations as well as our emphasis on examining and evaluating
risk management systems. In addition, last summer the Fed
established a supervisory policy requiring LCBOs to evaluate their
capital relative to their internal risk evaluations. Jointly with
other agencies, we have also established policies on the use of
synthetic credit instruments in securitizations and will soon
announce a policy on asset sales with recourse. All of these
efforts are designed to limit the disproportionate reduction in
regulatory capital requirements that might otherwise occur.
The Federal Reserve is also
dealing with implications arising from changing market structures
through senior level ad hoc groups. During the past year, for
example, the Board formed a group, the previously mentioned F-6,
to study the systemic implications of changing banking markets.
The group was originally composed of three Federal Reserve
governors and three Reserve Bank presidents and chaired by me.
Along the way, we added a fourth president but didn't change the
name. The F-numbered ad hoc groups, with the number depending on
size, have existed from time to time for the last ten years or so
and began when a governor decided to make a bit of sport of the
various G-designated groups that meet internationally. Now you
know all of our secrets!
During 1999, the current F-6
commissioned and reviewed several studies that have played a
significant role in shaping our evolving supervisory policy. These
studies addressed issues involving systemic risk, the potential
regulatory role of subordinated debentures, the value of public
disclosure, staff resource needs for supervising LCBOs, and other
supervisory issues. I would like to discuss some of these topics
in greater detail.
Public Disclosure
Greater public disclosure at LCBOs is an idea whose time has come.
As my colleagues and I struggled with the complexities of capital
reform in Basel, the systemic concerns of increasing scale and
concentration, the rising weight of the "C" in LCBO, the
burden and moral hazard of additional supervision and regulation,
and the accelerated speed with which markets respond to shock, we
concluded that harnessing markets to work in our behalf was a
necessity, not a choice. And, as I have already noted, markets
cannot operate well without transparency. Put another way, the
prerequisite for market discipline is more rapid dissemination of
information by the regulators and, more importantly, the direct
provision to market participants of critical and timely
information about risk exposures by the LCBOs themselves.
We are painfully aware of a
potentially difficult downside to public disclosure: the herdlike
withdrawal of funding in the event of bad news or surprise. As one
of my colleagues notes, the good news is that market discipline
will work. The bad news is that market discipline will work. That
risk is there but needs to be balanced by the ex ante
change in bank behavior that expanded public disclosure will
induce. We should also consider that more disclosure will induce
changes in funding costs when individual banks take on more risk.
Such responses should increase bank safety and soundness and
reduce risks and surprises.
Market discipline is not, of
course, the only instrument for disciplining the risk-taking of
banks; it may not even be the strongest pillar among the three.
But I have great expectations that it will become an effective
supplement to the supervisory process. I also hope that it will,
at least to some extent, substitute for additional future
regulation, if not permit a reduction in regulation. However, if
public disclosure does not induce meaningful market discipline,
there could be significant additional regulation--and more
intrusive supervision--as organizations increase in scale and
complexity.
A public version of the staff
F-6 paper on public disclosure will be published by the Board in a
month or so. It documents the significant amount of public
disclosure that already occurs at LCBOs, makes a case that current
disclosure is not sufficient, and suggests examples of kinds of
disclosures that might be helpful for the problem at hand. They
relate to the residual risks held in securitizations; the
distribution of credits by internal risk classification; and
concentrations of credits by industry, geography, and borrower. As
an aside, we understand that the work that the Federal Reserve has
published to date on internal systems for credit risk
classification and on analysis of economic capital has been
actively sought out by rating agencies, investors, and analysts,
who have repeatedly expressed strong support for more-meaningful
disclosure about bank risk profiles.
Let me underline that we are
still developing the LCBO public disclosure initiative, and we
hope to engage senior bank executives in helping us design the
program. We are fairly far along in designing what we have in
mind, but it is very much a work in progress. Let me share with
you our conceptual framework.
At least initially, we are
limiting application of the program to the LCBOs. For the domestic
LCBOs, only a little more than half of the organizations'
worldwide consolidated assets are funded from deposits, and not
all of their deposits are insured; 42 percent of assets are funded
by nondeposit debt, and 7 percent by equity. Market discipline
thus has a potential for significant impact. I noted that
one-third of the LCBOs are foreign-chartered banks. Any U.S.
disclosure policy would apply to only the U.S. operations of
foreign-chartered banks but to the consolidated worldwide
operations of U.S. chartered organizations.
Even though there are only about
thirty LCBOs, a one-size-fits-all disclosure requirement simply
would not work. The strategies, business mixes, and risk control
methods and policies among banks are simply too diverse and
rapidly changing. Rather than imposing a predetermined set of
statistics and reporting schedules for all LCBOs, we may require
some reverse engineering tailored for each bank. Each LCBO might
be asked to disclose information on the frequency and at the level
of detail that would be necessary for uninsured creditors and
other stakeholders to evaluate that LCBO's unique risk profile.
Lest you conclude that this is
some voluntary effort that LCBOs could meet in principle, but not
in fact, let me make three observations. First, I hope that the
Fed and the banking community can jointly develop a "best
practices" standard for public disclosure. Second, a best
practices standard will, it seems clear, set up considerable
market pressure on all LCBOs (as well as other large banks) to
disclose similar kinds of information. And, third, examiners will
be reviewing an LCBO's disclosures to confirm that the
organization's policy is consistent with best practices and to
confirm that the bank's actual disclosures are consistent with its
own policy.
Public disclosure is not going
to be easy for bankers because it may well bring new pressures
that they may not like in the short run. It is not going to be
easy on creditors and other stakeholders because they will have
some tough analysis to do, although it will greatly help them to
do a more effective job. It is not going to be easy on examiners
because they will have to make some tough judgments. But the
alternatives--more supervision and regulation--are not easy
either.
Subordinated Debentures
Beyond the broad public disclosure effort, Charlie Calomiris has
helped focus attention on the potential for subordinated
debentures as a way of increasing the degree of market discipline
in banking. Charlie has a quite specific proposal in mind, but I
would like to address a more generic model, applicable to LCBOs.
That broader model--built around investment grade unsecured
long-term debt issuance--is now almost required by the
Gramm-Leach-Bliley Act and is one of the hoops through which large
banks must jump if they want to operate securities subsidiaries of
the bank. In December 1999, the Board published a staff
study, under the direction of Myron Kwast and drawn from a
paper for the F-6, that analyzes the potential for using
subordinated debt as an instrument of market discipline. And the
Gramm-Leach-Bliley Act requires the Treasury and the Fed to
conduct a joint study evaluating the use of mandatory subordinated
debentures for large banks and financial holding companies.
Let me just highlight some of
the reasons policymakers might be interested in requiring LCBOs to
make subordinated debentures a part of--or a supplement to--Tier 2
capital requirements. Of course, the general principle, from which
all else flows, is that these instruments would provide a market
signal of the perceived riskiness of the issuer--directly at the
time of issue and indirectly in its secondary market price. These
instruments are particularly relevant because the holders have
interests similar to those of the Federal Deposit Insurance
Corporation (FDIC). Subordinated debt holders have an interest in
discouraging excessive risk-taking because their claims are both
long-term and junior to all depositors and any senior debt
holders, and they share in upside potential in very limited ways.
If the train crashes, the subordinated debt holders sit not in the
caboose but in the cab of the engine. They are thus quite
sensitive to the speed of the train and the quality of the tracks.
Another factor supporting the
regulatory use of subordinated debentures is that the market is
already well established--thirty-six of the fifty largest bank
holding companies have such instruments outstanding and held by
third parties today; eight of the fifty largest banks do as
well. The market is well defined and homogenous. Rates on
outstanding instruments adjust promptly to events, and the market
appears to closely monitor the spreads across issuers. Issuers
disclose considerable information at the time of issuance, and
such disclosure refreshes secondary market prices.
There are several things we do
not yet know. We do not know if the market behavior of these
instruments provides information to supervisors that they do not
already appreciate or if such information is provided earlier than
from other sources or is simply confirming. We do not yet have a
good understanding of how much additional market discipline would
be provided by mandatory subordinated debt relative to equity,
voluntary subordinated debt, and other uninsured liabilities. The
F-6 has asked the staff to study these and related matters, and
that effort is under way. In addition, we have asked the staff to
help us resolve some thorny analytical and practical questions.
Would a mandatory policy provide greater advantages than
current market practices? If there were a mandatory policy,
should it apply to banks or to holding companies? Which banks or
holding companies? Should it be a part of Tier 2 requirements or a
supplement? What should be the required minimum? How frequently
should issuance be required? What sort of issuance flexibility
should be permitted, especially at times of market or individual
bank stress?
While the Fed is not committed
to a specific policy as yet, my own view is that subordinated debt
will be shown to be quite useful as a supplement to supervision,
especially in conjunction with a broader program of additional
public disclosure and greater reliance on market discipline.
Perhaps we should not expect too much from these instruments,
taken alone, but I think they could be a useful part of a broader
program.
Let me end this discussion of
subordinated debt and public disclosure by noting and underlining
an obvious point. None of this will be worth the effort--indeed,
will not work--unless the market believes that the authorities
will refuse to rescue uninsured creditors of failed or reorganized
institutions. And that expectation cannot be sustained unless the
government and its agencies demonstrate it by their actual
behavior.
Other Issues
With my eye on the clock, let me briefly mention a couple of other
items that the F-6 has reviewed in recent months.
Decentralization is fundamental
to the culture of the Federal Reserve System, and I have been
impressed by how beneficial it is for obtaining intelligence about
banking, financial markets, and the macro and micro economy. The
presidents, their boards of directors, and the staffs of the
Reserve Banks are invaluable for providing the System with an
understanding of what is going on and helping ensure that the
policies developed in Washington are meaningful and relevant.
Nonetheless, the lack of
congruity between the geographical distribution of banks and
Federal Reserve Districts creates the potential for a
maldistribution of resources: Not every District can afford to
maintain the expert specialists that are required to examine the
LCBOs for which they are responsible, and other Districts may be
allocating their experts on District assignments with a lower
national priority. Therefore, to ensure reasonable resource
allocations consistent with System priorities, and as a result of
our F-6 discussions, we are in the process of recruiting a staff
coordinator to facilitate the allocation of scarce staff experts
at all the Reserve Banks to the highest System priority in LCBO
exams.
Another important issue involves
the cooperation and coordination among the many financial services
supervisors with complementary and sometimes overlapping
responsibilities within banking organizations. The wider scope of
financial activities for banking organizations authorized by the
Gramm-Leach-Bliley Act has made this an increasingly important
concern. There are potential tensions in the interaction between
the Federal Reserve as umbrella supervisor, on the one hand, and
the specialized functional regulators of nonbank activities--the
Security and Exchange Commission (SEC) and the state insurance
commissioners--on the other. Moreover, the increased complexity of
banking organizations requires improved cooperation and
coordination between the Federal Reserve as umbrella supervisor
and the primary bank supervisors, particularly the OCC, given that
most LCBOs have lead banks with national charters.
One final issue. As a matter of
prudent contingency planning, the F-6 reviewed the implications of
changes in markets and financial structure for central bank
management of LCBO failures. The review made clear that the speed
of financial market reactions to shocks has increased greatly.
This faster response reflects globalization, information
technology, banks' increased emphasis on short-term nondeposit
funding and securitization by banking organizations, the greater
participation in dealing and hedging markets by LCBOs, and the
increased scale of operations of the largest organizations. At the
same time, statutory and policy reforms have limited the options
available for addressing difficulties at individual institutions,
although I hasten to add that the tools available for macro policy
and short-term assistance to individual institutions remain
unchanged.
My colleagues and I carried away
from this review a greater appreciation of the need for
contingency planning by bank management for significant
disruptions--including the sale of units and business lines and
more active participation by outside directors. In addition, the
review emphasized the need for supervisors to be ready and willing
to intervene aggressively and rapidly when significant
difficulties occur. As a result, we are in the process of
reviewing and implementing a series of technical recommendations
to facilitate the resolution of a problem or failing bank by
regulatory agencies.
While such actions are needed,
the analysis and discussion of these issues have greatly
reinforced my view that we must rely more on market discipline in
an effort to create ex ante conditions that minimize
excessive risk-taking and that provide supervisors with rapid
signals when there are difficulties.
Conclusion
As I consider how to end my remarks today, I am reminded of the
story about the time Chico Marx was playing a zippy little melody
on the piano in Groucho's presence. It went on and on repeating
the same silly little tune with what seemed to be never-ending
regularity. Chico observed "That's funny, I can't think of
how to end this." To which Groucho responded, "That's
funny, that's all I can think about."