Regulators Support Bigger Role For Market in Curbing Banks

Humbled by the head-spinning pace of financial innovation, government officials agreed last week that the private sector must play a larger role in disciplining banks.

"Scale and complexity imply that the supervisor cannot alone accomplish the job," Federal Reserve Board Governor Laurence H. Meyer said. "We have no choice, therefore, but to rely increasingly on market discipline."

What's more, the risks facing the world's largest financial institutions are so interrelated today that supervision is only as strong as its weakest link. Speaker after speaker during a three-day confab here insisted that new international rules, such as capital requirements, must not only be adopted but also uniformly enforced.

"We are putting together rules for the world," declared Andrew Crockett, general manager of the Bank for International Settlements in Basel, Switzerland. "We are not averaging out existing rules but holding all to a higher standard."

The Bank for International Settlements, whose purpose is to ensure international financial stability by coordinating the world's central banks, co-sponsored the conference with the Federal Reserve Bank of Chicago to help supervisors learn from the financial crises of the last two years and strategize for the future.

A recurring theme was the need for more information to help investors evaluate the risks being taken by financial institutions. In fact, U.S. regulators were the most adamant -- and the most specific.

"Information on the risk categories of credit exposure, credit concentration, and exposure retained in securitizations is an example of the kind of disclosure that may be required," Mr. Meyer explained.

Kansas City Fed President Thomas M. Hoenig agreed, advocating "detailed disclosures" by banks such as market values of assets, internal credit ratings, and assessments of loan-loss reserve adequacy.

The Fed's director of banking supervision and regulation, Richard Spillenkothen, said banks could be required to disclose actual losses compared with those forecast by risk-management systems. He also called for more information about a bank's exposure to highly leveraged institutions.

"We intend to press" international regulators "very hard" to adopt rules requiring more extensive disclosures, he said.

Though both Mr. Hoenig and Mr. Spillenkothen said exam reports should remain confidential, Mr. Hoenig said supervisors should "become a greater force in ensuring that banks accurately disclose their condition to the markets."

Examiners, he said, know what's going on inside a bank, particularly its asset quality and risk management. "For example, examiners could ascertain whether all uncollectible assets have been charged off, loan-loss reserves are reflective of a bank's credit exposure, and other aspects of a bank's condition are accurately depicted on its balance sheet and in its public disclosures," he said.

"I might even suggest that bank management be required to comment regarding its assessment of supervisory examinations and to accurately disclose any material findings of the examiners."

Lest U.S. banks fear they are being singled out, the Basel Committee on Banking Supervision also "plans to issue more detailed guidance on the disclosure of capital structures, risk exposures, and capital adequacy later this year," said Daniele Nouy, the committee's secretary general.

"Much larger disclosure of the elements of the numerators and the denominator of the capital ratios, of the internal review process, and of accounting policies can achieve a lot in terms of market discipline," she said. (The committee is part of the Bank for International Settlements.)

In tandem with enhancing market discipline, the Basel committee is overhauling global capital standards. A June 3 proposal intended to replace a 1988 capital accord tries to more closely align a bank's reserves with the risks it faces. The plan has been widely criticized.

"The June document is a very open document," Ms. Nouy said. "It is more open than anything produced by the Basel committee in the past." She encouraged critics to comment by the March 31, 2000, deadline. After evaluating the comments, Ms. Nouy said, the committee will issue a second, "very different" draft in September 2000, with final implementation likely in late 2001.

New York Fed President William J. McDonough said the 1988 accord "has become not just meaningless but counterproductive." He, too, invited the industry to help supervisors come up with a "better measuring stick."

The June proposal advocated measuring the riskiness of some bank assets through independent rating agencies such as Standard & Poor's.

Citibank vice chairman H. Onno Ruding objected to the role envisioned for the rating agencies, saying they are not infallible or impartial and do not evaluate enough international borrowers. He suggested that a hybrid approach could rely on both rating agencies and a bank's internal assessments.

"Many banks have made major strides in developing internal rating systems," he said. "They should be rewarded by a more customized set of capital rules."

Mr. Ruding said some sophisticated banks are actually better positioned to judge an asset's risk -- and therefore the appropriate amount of capital backing -- than a rating agency.

"We have knowledge derived from exposure to a wider set of countries, companies, borrowers, and risks," Mr. Ruding said. The Citibank unit of Citigroup Inc. rates more than 15,000 credits a year in up to 100 countries, he said, adding that the bank's ratings have proven accurate when compared with those issued by agencies.

Michel Crouhy, a senior vice president in the market risk management division of Canadian Imperial Bank of Commerce, agreed that regulators ought to rely more on a bank's internal calculations. "The current capital regime is flawed," he said. The proposal does not reward diversification. One loan of $100 would require the same capital as 100 loans of $1, he explained. The plan also would not make fine enough distinctions among credits. For instance, a loan to GE Capital would require as much capital as a loan to a bank in the Czech Republic.

U.S. regulators seemed more willing to rely on banks' internal systems for setting capital requirements.

"We don't come up with the big ideas on credit risk management. Banks do," Mr. Meyer said. "We try to identify who is doing it best and encourage convergence."

Mr. Meyer said "it may be possible to immediately lever off" what banks are doing internally, but he added that few institutions have top-notch systems yet. Regulators, he said, must also improve their ability to evaluate these systems.

But the Basel committee's Ms. Nouy said, "It is clear that, because of a number of difficulties including data availability and models validation, credit risk models are not yet at the stage where they can play an explicit part in setting regulatory capital requirements."

Several speakers reminded regulators that market discipline and capital rules are undercut by the federal safety net and the belief that some financial institutions are too big to be allowed to fail.

"The fear of failure is no longer a deterrent of the big," said Anna Schwartz, an economist at the National Bureau of Economic Research. "I used to think price instability was the root of financial instability. Now I think it's the belief that whatever the excesses, the safety net will protect the bank from its follies."

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