"A perfectly safe bank, holding a portfolio of Treasury bills, is not doing the economy or its shareholders any good."
- Alan Greenspan at the conference of State Banking Supervisors, May 18, 2001.
Bad loans were up 26% last year at U.S. banks. Despite this fact, Federal Reserve Chairman Alan Greenspan and several Fed Governors have been emphasizing the need for increased competition between banks and acknowledging risk as a key factor in that competition. "The management and supervision of banking - especially bank risk taking - is in the process of fundamental change," Greenspan said at a conference of banking supervisors recently.
Perhaps the most concrete evidence to date of these fundamental changes are the modifications to the Basel accord, generally referred to as Basel II. "I suspect that the recently proposed changes to the Basel accord will affect your working lives rather dramatically," Governor Laurence H. Meyer told the Risk Management Association the day before Greenspan spoke. Both Greenspan and Meyer indicated that one of the major reasons for the policy changes is because of technological innovations in assessing risk. "Basel II is a response to changes flowing from the increasing sophistication of risk measurement and management," Meyer said.
If technology has made progress in assessing risk in the banking industry, it has also contributed significantly to increasing it. In fact, risks from electronic banking activities accounts for a great deal of the Basel II revisions. On May 3, of this year, the Basel Committee issued a report entitled Risk Management Principles for Electronic Banking which addresses cross - border banking and the risks inherent in transmitting information globally to countries that may have differing security standards.
Among the myriad of risk-related issues - electronic and otherwise - one can find a great deal of literature devoted to them in the form of Federal Reserve speeches, Basel Committee Reports and new FDIC guidelines. Bankers seeking guidance, however, will encounter more questions than answers. Why? Because few precedents have been set and because the regulators, including Chairman Greenspan, have been actively soliciting feedback from the industry before setting hard and fast rules.. "In setting boundaries and minimum standards for banks, we typically look at industry standards to identify what works well and what does not. In almost all cases, that's the correct approach - to build on industry practice," Greenspan said at the May 18th conference. The Federal Reserve and other regulatory bodies clearly have as much to learn as the banks they regulate.
Consistent with much of what Greenspan has constructed in the past 14 years, the Federal Reserve wishes for the new regulations to be market driven and competitively based. With roots easily traced back to his days within Ayn Rand's philosophical circle, Greenspan envisions the new regulatory procedures to be propped up by market incentives more than fear of censure or penalties. Consistent with this free market philosophy, much of the new regulatory ideas are geared towards less intrusive oversight and encouraging competition rather than hindering it. "If we can gain greater confidence in a bank's operating procedures and in its own evaluation of risk, we should be able to reduce our oversight role…" Greenspan said. It is The Federal Reserve's hope that by making banks more internally responsible for their own risk management and measurement, this can be used as a tool for shareholders to assess the banks investment worthiness, and consequently facilitating a higher share price in relation to earnings - thereby infusing self -regulation with free market competition.
Propping the burden of regulatory compliance against the incentive of free-market competition is a recurring theme throughout much of the new regulatory language arising in the past few months. "…under Basel II,
" Meyer said at the May 17th conference, " the practices that a strong and rigorous bank management would use on its own will be used to guide regulatory minimums," with the outcome being that "the parameters used to determine regulatory capital be the same as those that management uses to run the bank." Foreshadowing Greenspan's theme, Meyer noted that "Given informative and comparable disclosures of internal risk measures, the market will react more quickly and appropriately than any regulator to variations in risk postures, and such responses will help banks strike the right balance between risk and reward."
In short, much of the evolving framework of the Basel accord hinges upon the idea that improved transparency through more accurate risk measurement and more detailed disclosures will encourage banks to better manage a variety of different kinds of risk for the simple reason that it will enhance their competitiveness. Exactly how this will take place is yet to be seen. However, a number of indicators can be found in some of the other regulatory bodies' suggestions.
Take for instance the FDIC's recently released deposit insurance reform recommendations. One of the major concerns the new reform recommendations addresses is the longstanding issue of the distortions of economic incentives because deposit insurance cannot be priced effectively to reflect risk. With the proliferation of conglomerates as well as smaller niche-market banks, the need to address differing risk profiles in assessing capital standards has long been a thorn in the industry's side. Also, as FDIC Chairman Donna Tanoue points out, ""The lack of risk-based pricing for most institutions can encourage imprudent risk taking."
As with many of the modifications that the Basel accord proposes, few are opposing that FDIC insurance should follow a risk-based pricing model. The problem, as with the Basel accord, is exactly how this should be measured and assessed. One suggestion is to use a "scorecard" system to slot banks into different risk categories. The variables that should be included and the relative weight of each variable is still under review and may very well be for quite some time.
Some form of the scorecard could conceivably be used to address the transparency issues for the Basel accord. Could this all boil down to a rating system for banks similar to those used by Moody's and Standard and Poors' in order to assess the credit worthiness of municipal and corporate bonds? Perhaps a rating system of this nature would not accurately reflect the quality of business practices between different kinds of banks.
One idea that may counteract would be to have internal rating systems. One of the Basel accord's recommendations is to give banks the option of an internal ratings system to assess their own risk. Conditional on a supervisors acceptance, qualifying banks would be permitted to assign individual credits to distinct credit risk categories based on their internal ratings.
Greenspan also endorses the self-policing approach, clearly favoring a healthy competitive environment over concerns about bank failures. One of his long-term goals, as stated at his May 18 conference is "to maintain a supervisory and regulatory environment that encourages innovation and efficient competition in financial services and that does not require excessive risk-taking by banks in order to generate competitive returns."
Other Fed pronouncements lately have been geared towards accommodating different banks' business models. For instance, consider the testimony of Vice Chairman Roger W. Ferguson, Jr. before the House's Small Business Committee on May 17. His testimony pointed out that small businesses are increasingly seeking out smaller banks for their financing and credit needs and that risk is an inherent part of lending to this business sector. Clearly the Fed recognizes the economic importance of keeping the lines of credit open to this sector. "The possibility that an idea or new product will eventually transform a small business into a large corporation is a great motivator of change and risk taking, " Ferguson stated.
Both Greenspan and Ferguson seem to be on the same wavelength when it comes to tailoring their supervision to the needs of the particular banks business model without hindering it from functioning successfully as a business - even if that business should incur a greater than average amount of risk.
Rather than punishing a particular bank for necessarily incurring more risk - according to the business sector they serve - reforms sought by the Basel accord and the FDIC will serve to level the playing field by acknowledging differing risk profiles and encouraging competition.
Although the details have yet to be worked out, it is clear that sophisticated risk management techniques will play a much greater role in 21st century banking than it did in the previous century, forcing bankers to become much more active in designing their own risk parameters.
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