Regulators are not prepared to scrap fixed regulatory capital requirements in favor of internal models developed by large banks, Federal Reserve Board Chairman Alan Greenspan said Thursday.
"It would seem that a full-fledged, bankwide internal models approach could require a very substantial amount of time and effort to develop," he said before a conference on capital regulation sponsored by the Federal Reserve Bank of New York.
Mr. Greenspan pointed out that recent Fed studies raise concerns about the reliability of credit-risk models that big banks use today.
Nevertheless, he said, regulators should use bank models as part of their current effort to devise new capital standards. "Bank supervisors should continually find ways to incorporate market advances into their prudential policies," he said.
Mr. Greenspan said two internal-model approaches do offer "promising" alternatives for the future because any new capital standard is likely to become obsolete quickly.
"Proponents of an internal-models approach to capital regulation may be on the right track," he said.
One alternative would simply replace the current requirements, which establish capital levels for various activities on the basis of their risk, with banks' internal models, provided they are approved by regulators.
Another, the so-called "precommitment approach," would let banks set capital levels for their trading activities without having regulators sanction their internal models. Banks would be hit with big fines if they underestimated how large their reserves should be.
Mr. Greenspan said regulators will be forced to revise their capital rules repeatedly to adjust for innovations in risk management.
He compared the task to conditions in the computer chip industry, which is constantly developing new generations of micro-processors.
"Just as manufacturing companies follow a product planning cycle, bank regulators can expect to begin working on still another generation of prudential policies even as proposed modifications to the current standards are being released for public comment," he said.
In setting new standards, regulators must act "as the market would if there were no safety net," he said. That means capital requirements should not be so high that bank lending is restricted excessively nor so low that institutions would earn "junk-bond status."