Alan Greenspan Federal Reserve Bank of New York

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Alan Greenspan Federal Reserve Bank of New York Powered By Docstoc
					The Role of Capital in Optimal
Banking Supervision and Regulation
Alan Greenspan

It is my pleasure to join President McDonough and our col-                          Of course, the focus of this conference is on the
leagues from the Bank of Japan and the Bank of England in                 future of prudential capital standards. In our deliberations,
hosting this timely conference. Capital, of course, is a topic            we must therefore take note that observers both within the
of never-ending importance to bankers and their counter-                  regulatory agencies and in the banking industry itself are
parties, not to mention the regulators and central bankers                raising warning flags about the current standard. These
whose job it is to oversee the stability of the financial sys-            concerns pertain to the rapid technological, financial, and
tem. Moreover, this conference comes at a most critical and               institutional changes that are rendering the regulatory
opportune time. As you are aware, the current structure of                capital framework less effectual, if it is not on the verge of
regulatory bank capital standards is under the most intense               becoming outmoded, with respect to our largest, most
scrutiny since the deliberations leading to the watershed                 complex banking organizations. In particular, it is argued
Basle Accord of 1988 and the Federal Deposit Insurance                    that the heightened complexity of these large banks’ risk-
Corporation Improvement Act of 1991.                                      taking activities, along with the expanding scope of
         In this tenth anniversary year of the Accord, its                regulatory capital arbitrage, may cause capital ratios as
architects can look back with pride at the role played by                 calculated under the existing rules to become increasingly
the regulation in reversing the decades-long decline in bank              misleading.
capital cushions. At the time that the Accord was drafted,                          I, too, share these concerns. In my remarks this
the use of differential risk weights to distinguish among                 evening, however, I would like to step back from the tech-
broad asset categories represented a truly innovative and,                nical discourse of the conference’s sessions and place these
I believe, effective approach to formulating prudential                   concerns within their broad historical and policy contexts.
regulations. The risk-based capital rules also set the stage              Specifically, I would like to highlight the evolutionary
for the emergence of more general risk-based policies                     nature of capital regulation and then discuss the policy
within the supervisory process.                                           concerns that have arisen with respect to the current capital
                                                                          structure. I will end with some suggestions regarding basic
Alan Greenspan is the chairman of the Board of Governors of the Federal   principles for assessing possible future changes to our
Reserve System.                                                           system of prudential supervision and regulation.

                                                                          FRBNY ECONOMIC POLICY REVIEW / OCTOBER 1998                163
         To begin, financial innovation is nothing new, and      suited to the times for which they were developed or will
the rapidity of financial evolution is itself a relative con-    be ill suited for those banking systems that are at an earlier
cept—what is “rapid” must be judged in the context of the        stage of development.
degree of development of the economic and banking struc-                   Indeed, so long as we adhere in principle to a com-
ture. Prior to World War II, banks in this country did not       mon prudential standard, it is appropriate that differing
make commercial real estate mortgages or auto loans. Prior       regulatory regimes may exist side by side at any point in
to the 1960s, securitization, as an alternative to the tradi-    time, responding to differing conditions between banking
tional “buy and hold” strategy of commercial banks, did          systems or across individual banks within a single system.
not exist. Now banks have expanded their securitization          Perhaps the appropriate analogy is to computer-chip manu-
activities well beyond the mortgage programs of the 1970s        facturers. Even as the next generation of chip is being
and 1980s to include almost all asset types, including cor-      planned, two or three generations of chip—for example,
porate loans. And most recently, credit derivatives have         Pentium IIs, Pentium Pros, and Pentium MMXs—are
been added to the growing list of financial products. Many       being marketed, and at the same time, older generations of
of these products, which would have been perceived as too        chip continue to perform yeoman duty within specific
risky for banks in earlier periods, are now judged to be safe    applications. Given evolving financial markets, the ques-
owing to today’s more sophisticated risk measurement and         tion is not whether the Basle standard will be changed but
containment systems. Both banking and regulation are             how and why each new round of change will occur and to
continuously evolving disciplines, with the latter, of           which market segment it will apply.
course, continuously adjusting to the former.                              As it oversees the necessary evolution of the Accord
         Technological advances in computers and in tele-        for the more advanced banking systems, the regulatory
communications, together with theoretical advances—              community would do well to address some of the basic
principally in option-pricing models—have contributed to         issues that, in my view, it has not adequately addressed to
this proliferation of ever more complex financial products.      date. In so doing, perhaps we can shed some light on the
The increased product complexity, in turn, is often cited as     source of our present concerns with the existing capital
the primary reason that the Basle standard is in need of         standard. There really are only two questions here: First,
periodic restructuring. Indeed, the Basle standard, like the     How should bank “soundness” be defined and measured?
industry for which it is intended, has not stood still over      Second, What should be the minimum level of soundness
the past ten years. Since its inception, significant changes     set by regulators?
have been made on a regular basis to the Accord, includ-                   When the Accord was being crafted, many super-
ing, most visibly, the use of banks’ internal models to assess   visors may have had an implicit notion of what they meant
capital charges for market risk within trading accounts. All     by soundness—they probably meant the likelihood of a
of these changes have been incorporated within a document        bank becoming insolvent. Although by no means the only
that is now quite lengthy—and written in appropriately           one, this definition of soundness is perfectly reasonable.
dense, regulatory style.                                         Indeed, insolvency probability is the standard explicitly
         While no one is in favor of regulatory complexity,      used within the internal risk measurement and capital allo-
we should be aware that capital regulation will necessarily      cation systems of our major banks. That is, many of the
evolve over time as the banking and financial sectors them-      large banks explicitly calculate the amount of capital they
selves evolve. Thus, it should not be surprising that we         need in order to reduce to a targeted percentage the proba-
constantly need to assess possible new approaches to old         bility, over a given period, that losses would exceed the
problems, even as new problems become apparent. Nor              allocated capital and drive the bank into insolvency.
should the continual search for new regulatory procedures                  But whereas our largest banks have explicitly set
be construed as suggesting that existing policies were ill       their own internal soundness standards, regulators really

have not. Rather, the Basle Accord set a minimum capital          information systems and internal systems for quantifying,
ratio, not a maximum insolvency probability. Capital, being       pricing, and managing risk.
the difference between assets and liabilities, is of course an             It is appropriate that supervisory procedures evolve
abstraction. Thus, it was well understood at the time that        to encompass the changes in industry practices, but we
the likelihood of insolvency is determined by the level of        must also be sure that improvements in both the form
capital a bank holds, the maturities of its assets and liabili-   and the content of the formal capital regulations keep
ties, and the riskiness of its portfolio. In an attempt to        pace. Inappropriate regulatory capital standards, whether
relate capital requirements to risk, the Accord divided           too low or too high in specific circumstances, can entail sig-
assets into four risk “buckets,” corresponding to minimum         nificant economic costs. This resource allocation effect of
total capital requirements of 0 percent, 1.6 percent,             capital regulations is seen most clearly by comparing the
4.0 percent, and 8.0 percent, respectively. Indeed, much of       Basle standard with the internal “economic capital” alloca-
the complexity of the formal capital requirements arises          tion processes of some of our largest banking companies.
from rules stipulating which risk positions fit into which        For internal purposes, these large institutions attempt
of the four capital buckets.                                      explicitly to quantify their credit, market, and operating
         Despite the attempt to make capital requirements         risks by estimating loss probability distributions for various
at least somewhat risk-based, the main criticisms of the          risk positions. Enough economic, as distinct from regula-
Accord—at least as applied to the activities of our largest,      tory, capital is then allocated to each risk position to satisfy
most complex banking organizations—appear to be war-              the institution’s own standard for insolvency probability.
ranted. In particular, I would note three: First, the formal      Within credit risk models, for example, capital for internal
capital ratio requirements, because they do not flow from         purposes often is allocated so as to hypothetically “cover”
any particular insolvency probability standard, are for the       99.9 percent or more of the estimated loss probability
most part arbitrary. All corporate loans, for example, are        distribution.
placed into a single, 8 percent bucket. Second, the require-               These internal capital allocation models have
ments account for credit risk and market risk but not             much to teach the supervisor and are critical to under-
explicitly for operating and other forms of risk that may         standing the possible misallocative effects of inappropriate
also be important. Third, except for trading account              capital rules. For example, the Basle standard lumps all
activities, the capital standards do not take account of          corporate loans into the 8 percent capital bucket, but the
hedging, diversification, and differences in risk manage-         banks’ internal capital allocations for individual loans vary
ment techniques, especially portfolio management.                 considerably—from less than 1 percent to well over 30 per-
         These deficiencies were understood even as the           cent—depending on the estimated riskiness of the position
Accord was being crafted. Indeed, it was in response to           in question. In the case in which a group of loans attracts
these concerns that, for much of the 1990s, regulatory            an internal capital charge that is very low compared with
agencies focused on improving supervisory oversight of            the Basle 8 percent standard, the bank has a strong incentive
capital adequacy on a bank-by-bank basis. In recent years,        to undertake regulatory capital arbitrage to structure the
the focus of supervisory efforts in the United States has         risk position in a manner that allows it to be reclassified
been on the internal risk measurement and management              into a lower regulatory risk category. At present, securitiza-
processes of banks. This emphasis on internal processes has       tion is, without a doubt, the major tool used by large U.S.
been driven partly by the need to make supervisory policies       banks to engage in such arbitrage.
more risk-focused in light of the increasing complexity of                 Regulatory capital arbitrage, I should emphasize,
banking activities. In addition, this approach reinforces         is not necessarily undesirable. In many cases, regulatory
market incentives that have prompted banks themselves to          capital arbitrage acts as a safety valve for attenuating the
invest heavily in recent years to improve their management        adverse effects of those regulatory capital requirements that

                                                                  FRBNY ECONOMIC POLICY REVIEW / OCTOBER 1998                 165
are well in excess of the levels warranted by a specific activ-   requirements on the assets remaining on the book. In the
ity’s underlying economic risk. Absent such arbitrage, a          extreme, such “cherry picking” would leave on the balance
regulatory capital requirement that is inappropriately high       sheet only those assets for which economic capital allocations
for the economic risk of a particular activity could cause a      are greater than the 8 percent regulatory standard.
bank to exit that relatively low-risk business by preventing               Given these difficulties with the one-size-fits-all
the bank from earning an acceptable rate of return on its         nature of our current capital regulations, it is understand-
capital. That is, arbitrage may appropriately lower the           able that calls have arisen for reform of the Basle standard.
effective capital requirements against some safe activities       It is, however, premature to try to predict exactly how the
that banks would otherwise be forced to drop by the effects       next generation of prudential standards will evolve. One
of regulation.                                                    set of possibilities revolves around market-based tools and
          It is clear that our major banks have become quite      incentives. Indeed, as banks’ internal risk measurement
efficient at engaging in such desirable forms of regulatory       and management technologies improve, and as the depth
capital arbitrage, through securitization and other devices.      and sophistication of financial markets increase, bank
However, such arbitrage is not costless and therefore not         supervisors should continually find ways to incorporate
without implications for resource allocation. Interestingly,      market advances into their prudential policies, when
one reason that the formal capital standards do not include       appropriate. Two potentially promising applications of this
very many risk buckets is that regulators did not want to         principle have been discussed at this conference. One is the
influence how banks make resource allocation decisions.           use of internal credit risk models as a possible substitute
Ironically, the “one-size-fits-all” standard does just that, by   for, or complement to, the current structure of ratio-based
forcing the bank into expending effort to negate the capital      capital regulations. Another approach goes one step further
standard, or to exploit it, whenever there is a significant       and uses market-like incentives to reward and encourage
disparity between the relatively arbitrary standard and           improvements in internal risk measurement and manage-
internal, economic capital requirements.                          ment practices. A primary example is the proposed pre-
          The inconsistencies between internally required         commitment approach to setting capital requirements for
economic capital and the regulatory capital standard create       bank trading activities. I might add that precommitment
another type of problem: Nominally high regulatory capi-          of capital is designed to work for only the trading account,
tal ratios can be used to mask the true level of insolvency       not the banking book, and then for only strong, well-
probability. For example, consider the case in which the          managed organizations.
bank’s own risk analysis calls for a 15 percent internal                   Proponents of an internal-models-based approach
economic capital assessment against its portfolio. If the         to capital regulations may be on the right track, but at
bank actually holds 12 percent capital, it would, in all          this moment of regulatory development, it would seem
likelihood, be deemed to be well capitalized in a regulatory      that a full-fledged, bankwide, internal models approach
sense, even though it might be undercapitalized in the            could require a very substantial amount of time and
economic sense.                                                   effort to develop. In a paper given earlier today, Federal
          The possibility that regulatory capital ratios may      Reserve Board economists David Jones and John Mingo
mask true insolvency probability becomes more acute as            enumerate their concerns about the reliability of the
banks arbitrage away inappropriately high capital require-        current generation of credit risk models. They suggest,
ments on their safest assets by removing these assets from        however, that these models may, over time, provide a
the balance sheet via securitization. The issue is not solely     basis for setting future regulatory capital requirements.
whether capital requirements on the bank’s residual risk          Even in the shorter term, they argue, elements of internal
in the securitized assets are appropriate. We should also         credit risk models may prove useful within the super-
be concerned with the sufficiency of regulatory capital           visory process.

          Still other approaches are of course possible,                    Conversely, permitting regulated institutions that
including some combination of market-based and tradi-             benefit from the safety net to take risky positions that, in
tional ratio-based approaches to prudential regulation. But       the absence of the net, would earn them junk bond ratings
regardless of what happens in this next stage, as I noted         for their liabilities is clearly inappropriate. In such a world,
earlier, any new capital standard is itself likely to be super-   our goals of protecting taxpayers and reducing the mis-
ceded within a continuing process of evolving prudential          allocative effects of the safety net would simply not be
regulations. Just as manufacturing companies follow a             realized. Ultimately, the setting of soundness standards
product-planning cycle, bank regulators can expect to             should achieve a complex balance—remembering that the
begin working on still another generation of prudential           goals of prudential regulation should be weighed against
policies even as proposed modifications to the current            the need to permit banks to perform their essential risk-
standard are being released for public comment.                   taking activities. Thus, capital standards should be struc-
          In looking ahead, supervisors should, at a mini-        tured to reflect the lines of business and the degree of risk
mum, be aware of the increasing sophistication with which         taking chosen by the individual bank.
banks are responding to the existing regulatory framework                   A second principle should be to continue linking
and should now begin active discussions on the necessary          strong supervisory analysis and judgment with rational
modifications. In anticipation of such discussions, I would       regulatory standards. In a banking environment charac-
like to conclude by focusing on what I believe should be          terized by continuing technological advances, this means
several core principles underlying any proposed changes to        placing an emphasis on constantly improving our super-
our current system of prudential regulation and supervision.      visory techniques. In the context of bank capital adequacy,
          First, a reasonable principle for setting regulatory    supervisors increasingly must be able to assess sophisti-
soundness standards is to act much as the market would if         cated internal credit risk measurement systems and to
there were no safety net and all market participants were         gauge the impact of the continued development in securi-
fully informed. For example, requiring all of our regulated       tization and credit derivative markets. It is critical that
financial institutions to maintain insolvency probabilities       supervisors incorporate, where practical, the risk analysis
that are equivalent to a triple-A rating standard would be        tools being developed and used on a daily basis within the
demonstrably too stringent because there are very few such        banking industry itself. If we do not use the best analytical
entities among unregulated financial institutions not subject     tools available and place these tools in the hands of highly
to the safety net. That is, the markets are telling us that the   trained and motivated supervisory personnel, then we
value of the financial firm is not, in general, maximized at      cannot hope to supervise under our basic principle—
default probabilities reflected in triple-A ratings. This sug-    supervision as if there were no safety net.
gests, in turn, that regulated financial intermediaries cannot              Third, we have no choice but to continue to plan
maximize their value to the overall economy if they are           for a successor to the simple risk-weighting approach to
forced to operate at unreasonably high levels of soundness.       capital requirements embodied within the current regula-
          Nor should we require individual banks to hold          tory standard. While it is unclear at present exactly what
capital in amounts sufficient to protect fully against rare       that successor might be, it seems clear that adding more
systemic events, which, in any event, may render standard         and more layers of arbitrary regulation would be counter-
probability evaluation moot. The management of systemic           productive. We should, rather, look for ways to harness
risk is properly the job of the central banks. Individual         market tools and market-like incentives whenever possible,
banks should not be required to hold capital against the          by using banks’ own policies, behaviors, and technologies
possibility of overall financial breakdown. Indeed, central       in improving the supervisory process.
banks, by their existence, appropriately offer banks a form of              Finally, we should always remind ourselves that
catastrophe insurance against such events.                        supervision and regulation are neither infallible nor likely

                                                                  FRBNY ECONOMIC POLICY REVIEW / OCTOBER 1998                 167
to prove sufficient to meet all our intended goals. Put              efforts to contain the scope of the safety net or to press for
another way, the Basle standard and the bank examination             increases in the quantity and quality of financial disclosures
process, even if structured in optimal fashion, are a second         by regulated institutions.
line of support for bank soundness. Supervision and regula-                    If we follow these basic prescriptions, I suspect
tion can never be a substitute for a bank’s own internal             that history will look favorably on our attempts at crafting
scrutiny of its counterparties and for the market’s scrutiny         regulatory policy.
of the bank. Therefore, we should not, for example, abandon

  The views expressed in this article are those of the author and do not necessarily reflect the position of the Federal Reserve
  Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or
  implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any information
  contained in documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.


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