While international regulators struggle to rewrite global risk-based capital rules, here at home the Federal Reserve Board is quietly forging ahead with new ways to supervise the world's largest banks.
In two recent letters to bankers and their examiners, the Fed outlined how its oversight of roughly 32 U.S. and foreign banking companies is evolving.
The first letter, dated June 23, explains that a senior examiner, working with a team of specialists, will be assigned to each of these large banks. The supervisors will assess a bank's risk management processes and monitor its risk profile. Oversight will be tailored to the institution's principal business lines and risks, and its performance will be compared with its peers', according to the 10-page letter.
The second letter, dated July 1, zeros in on how these "large complex banking organizations" determine how much capital to hold.
These banks-roughly 20 U.S. banks and 12 foreign banks operating here- must "tie the identification, monitoring, and evaluation of risk to the determination of the institution's capital needs," according to the 11-page letter.
In other words, banks must integrate capital setting with risk management.
"This is a bombshell," said John Mingo, who left the Fed's supervisory staff this month to start a consulting firm. "This is the most important supervisory letter ever published, because for the first time it requires the large banks to have internal capital measurement procedures."
In fact, the Fed said it decided to write this letter after a survey of a few large banks showed that current practice "could be significantly improved."
"Most banks have a long way to go in terms of establishing a consistent internal economic capital measurement process across all business lines, or all kinds of risks," Mr. Mingo said.
Both letters build on the recent regulatory trend toward focusing on the quality of a bank's internal controls and risk management.
The Fed wants a bank be able to demonstrate, through an internal analysis tailored to its particular business lines, that capital is adequate to support the risks it is taking. A cushion for unexpected events should be included.
The Fed told examiners not to expect immediate compliance.
"Examiners should evaluate an institution's progress ... considering progress both relative to the institution's former practice and relative to its peers," the letter states.
For now, the results will affect the "management" grade in a bank's Camels rating. Eventually, the Fed said, the capital grade will also be affected. (Camels is a 1-5 system rating a bank's capital, asset quality, management, equity, liquidity, and sensitivity to risk.)
The Fed acknowledged that there is no one right way to determine internal capital needs. But it is clear that it is no longer enough to merely satisfy regulatory capital requirements.
"With the growing scope and complexity of business activities," the Fed said, "supervisors ... cannot rely on risk-based capital ratios as indicators of capital strength."
Still, international regulators, including the Fed, will continue to try and improve the risk-based capital standards. A June 3 proposal issued by the Basel Committee on Bank Supervision would base capital requirements on the riskiness of a bank's borrowers. Under current rules, capital is based on the type of assets a bank holds. Comments on the proposal are not due until March 31 and a final rule could take years to develop.
"We're working with them on a new Basel accord, but at the same time we're moving ahead more quickly than that process to assess the quality of internal capital measurement," Mr. Mingo said.
