Recent proposals to revise the Basel Accord, the 11-year-old multinational agreement that established a framework for global banking regulation, create a historic opportunity for bankers to help reshape their regulatory environment for years to come. We need to begin now to work aggressively with regulators to ensure that this work produces a risk-based capital framework as modern and responsive as the financial services industry has become.
Frankly, much work needs to be done. The accord of 1988 was a welcome step forward, establishing more consistent capital requirements for banks worldwide and reducing a competitive disadvantage for U.S. banks. But even as it leveled the playing field for the world's banks, it tilted the field against banks in some of the highest-quality lending markets. In fact, it created incentives for banks to shift their lending down the asset-quality curve, counter to the goal of safety and soundness.
Why? The accord was -- and is -- based almost entirely on minimum capital requirements. Though it conceptually recognizes credit risk variations, in reality it largely ignores borrower creditworthiness, loan tenor, or the quality of lender risk management programs. For example, any bank must allocate 8% capital to support an investment-grade corporate loan for which a nonbank lender may be able to get by safely with 1% -- a huge competitive disparity.
Similar rigidities in consumer lending ensure that nearly all banks are weakened at the high end of their lending markets, and this gives them an incentive to pursue lower-quality loans. Banks also are encouraged to focus resources on reducing their regulatory capital requirements rather than their actual risk positions, which is known in the industry as regulatory arbitrage.
I believe the revisions, as currently proposed, are encouraging in direction but disappointing in detail. They need intense industry scrutiny.
Minimum capital requirements would be only modestly more sensitive to variations in economic risk, and these changes would affect few banks.
As currently proposed, they would continue to ignore loan tenor and risk variations in consumer credit. They need a vigorous push toward better risk differentiation.
Beyond minimum capital requirements -- the first "pillar" as defined in the proposal -- there are two other pillars.
One is supervisory review. A bank-by-bank model of U.S. regulators would focus on the quality of each bank's internal risk analysis and management.
The other is market discipline. Stronger standards for public disclosure of risks and risk management processes would let the market supply economic incentives for better risk management and discipline for those who ignore it.
The importance of fashioning these pillars correctly cannot be understated. They would create a solid foundation upon which to build a regulatory framework that makes economic sense in the new millennium.
That framework can be further strengthened with the broader use of increasingly sophisticated risk-grading and risk management techniques and programs that have made enormous strides over the past decade. At Key, for example, advanced quantitative analysis and modeling help us aggregate credit risk across all lines of business. Tools such as value-at-risk enable us to better measure corporate exposure to market risk.
In short we have the means to differentiate risk by product, activity, or line of business. From such a base we can build internal capital allocation models that are far more sensitive to actual economic risks than the proposed Basel system.
In my organization we assign economic capital to each business line in proportion to overall risk exposure after adjusting for the quality of its risk management system. This gives line managers economic incentives to develop risk management capabilities in direct proportion to the risks they face. Other large banking organizations have built analogous models and incentives, and I have no doubt that they can eventually be cost-effective for smaller banks.
This progress points toward a more nearly ideal regulatory framework that is technically, economically, and politically possible in the foreseeable future.
It would rely heavily on banks' internal risk management systems, including reliable and continually improving variants of today's technologies for measuring and monitoring risks and allocating capital.
Regulatory processes, which also are continually improving, will have the flexibility to make regulatory capital allocation truly risk-based. Market discipline, then, will help both banks and regulators recognize problems earlier than they could previously.
To reach this point, however, we must overcome understandable concerns such as the reliability of our models, having institutions build their own models, the measurement of operating risk, and ensuring checks on reckless or dishonest operators.
Our challenge is to develop and deliver the information needed to fill in the missing details, answer the concerns, and speed the Basel committee and our own regulators toward such a goal. Federal Reserve Chairman Alan Greenspan has suggested that this will require "unprecedented collaboration" among regulators and bankers, and I agree.
Regulators correctly challenge us to invest in controls and technology proportional to the changing risks we face. I believe we also have a responsibility to challenge regulators to make their approaches more responsive to change. We know what a risk-based capital framework should look like, and we have the opportunity to help create it. The proposals are open for comment until March, so let's get to it.