Federal Reserve Board Vice Chairman Alice M. Rivlin said Thursday that regulatory capital reserves no longer accurately reflect the riskiness of a bank's activities.
"The scope and complexity of banking activities has proceeded apace during the last two decades or so," Ms. Rivlin said. "Standard capital measures, at least for our very largest and most complex organizations, are no longer adequate measures on which to base supervisory actions."
Speaking at a Brookings Institution conference, Ms. Rivlin said regulatory capital standards protect only against fluctuations in credit and interest rate risks. Risks from a bank's internal controls or information systems are not addressed, she said.
Even for risks that are addressed by regulatory capital standards, the current rules are too arbitrary, she said. Ms. Rivlin noted that nonmortgage loans to corporations and households receive the same 8% capital requirement.
In addition, the current risk-based standards do not reward banks that mitigate risks by entering into credit derivative contracts and similar transactions, she said.
"The simple regulatory capital standards that apply to all banks can be quite misleading," Ms. Rivlin said.
Banks are getting ahead of regulators by developing their own internal models to allocate capital among their business lines, she said. Through these models, banks devote enough capital to a particular activity to ensure that there is a small, well-defined probability that losses would exceed reserves.
"What these bankers have actually done themselves ... is something regulators have never done - defined a bank soundness target," Ms. Rivlin said. Even if regulators require high risk-based capital ratios, the current system cannot predict problems that can stem from a risky portfolio, she added.
"The question should not be how high is the bank's capital ratio, but how low is the failure probability," Ms. Rivlin said.
In the area of market risk, the Fed is currently testing an approach to setting capital that would rely on a bank's capital allocation models. In the so-called precommitment approach, a bank would estimate its capital requirements on the basis of internal models, and would be fined by regulators if it underestimated its needs.
"The solution may be for the regulators to use the analytical tools developed by the market participants themselves for risk and performance assessment," Ms. Rivlin said.