WASHINGTON - In what Fed Chairman Alan Greenspan described as a major step into the future of banking regulation, the Federal Reserve Board on Wednesday proposed letting banks decide for themselves how much capital they need to set aside for their trading operations.
Mr. Greenspan said that rapid changes in technology and communications were making old-style banking supervision obsolete, and that the proposed new approach "could be extraordinarily useful as our next 'Pentium chip.'"
The idea was presented in the form of a trial balloon - the board voted unanimously to publish it in the Federal Register as a "request for comment" to see if banks and other interested parties think it is feasible.
It came up at Wednesday's meeting immediately after the board approved a more concrete proposed regulation that would let banks judge market risks using their own internal models instead of regulatory formulas.
That rule, based on a proposal issued April 12 by the Basel Committee on Banking Supervision, would still require regulatory review and approval of banks' risk assessment models.
"The current proposal is clearly a major advance over where we've been," Mr. Greenspan said. But, he added, "like the Pentium chip and its predecessor, you develop a new technology before the previous technology is even introduced."
How would the "new technology" proposed in the Fed's regulatory trial balloon work?
"The approach would require a bank to specify the amount of capital it chose to allocate to support market risks and to commit to manage its trading portfolio so as to limit any cumulative trading losses over some subsequent interval ... to an amount less than the capital allocation," said Patrick Parkinson, associate director of the Fed's division of research and statistics, in his presentation to the board.
"To ensure that the bank committed an amount of capital commensurate with the risks of its trading portfolios and its capacity to manage those risks," Mr. Parkinson continued, "the regulator would need to provide appropriate economic incentives in the form of economic costs or 'penalties' for failing to limit losses to less than the capital commitment."
The most effective penalties, Mr. Parkinson said, might be those imposed by the market if a bank exceeded its own publicly disclosed loss limit.
Other Federal Reserve Board members were as gung ho about the idea as Mr. Greenspan. "A huge virtue of this ... is the absence of a need to try to micromanage what's going on," said Vice Chairman Alan S. Blinder. "Via public disclosure, you bring to bear market discipline on this requirement that's difficult for regulators to bring to bear."
The proposal came as a surprise to Fed observers.
"It's been discussed by some analysts and academics," said banking consultant Karen Shaw, president of ISD/Shaw Inc. in Washington. "I had not thought it had reached the level of the regulatory agencies.
"It's a really good idea," she added.