A Federal Reserve System task force reported Friday that banks' internal credit risk models could eventually be used to set formal capital requirements for certain assets.
"Credit risk models are progressing so rapidly it is conceivable they could become the foundation for a new approach to setting formal regulatory capital requirements," the report concluded.
For now, however, the Fed task force is only suggesting that internal models may be a substitute for capital requirements on assets that are not accurately measured by the current risk-based capital standards.
Credit enhancements supporting securitization programs are one example, the report said, because these assets did not exist when risk-based capital was created in 1988.
"The application of internal credit risk models ... could provide the first practical means of assigning economically reasonable capital requirements against such instruments," the report said.
Refining risk-based capital has been a priority at the Fed for some time, but the effort has picked up momentum this year.
In February the central bank, along with supervisors in England and Japan, hosted a two-day conference devoted to creating the next generation of capital standards. At that meeting, Fed Chairman Alan Greenspan threw his weight behind efforts to refine risk-based capital and argued that regulators need to find a way to incorporate the work being done by large banks.
These banks are using cutting-edge technology to assess their capital needs. Though regulators want to piggyback on this work, they are wary of relying too heavily on results generated by a bank's own models.
Though the task force said risk-based capital cannot be abandoned just yet, the report does conclude that examiners quickly "need to improve their existing methods for assessing bank capital adequacy, which are rapidly becoming outmoded in the face of technological and financial innovation."
The report identified several issues that must be addressed before risk- based capital can be replaced by internal bank models. For example, to build an accurate model data must be available on such things as actual credit losses over long periods, including over one or more business cycles. More systematic and comprehensive methods also must be developed to validate models, according to the report.
The 11-member task force, which began work 18 months ago, will continue to work on answers to these problems. The task force consists of staff members from the Federal Reserve Board, as well as from the reserve banks in New York, Chicago, and San Francisco. Roger Cole, an associate director in the Fed's supervision division, and John Mingo, a senior adviser in the research and statistics section, are chairmen.
Regulators are taking changes to capital rules one step at a time. On Jan. 1 roughly 20 large banks were permitted to use internal models to set capital levels for trading assets.