WASHINGTON - Future examinations of large financial holding companies will include an assessment of the meaningfulness of information they disclose to the public, Federal Reserve Board Governor Laurence H. Meyer said Wednesday.
In a speech to the Federal Financial Institutions Examination Council, Mr. Meyer reiterated the Fed's belief that market discipline will play an increasingly large role in bank supervision, and he called public disclosure a "necessary prerequisite" for it to be effective.
To that end, he said, the Fed will expect banks to release sufficient data about their lending practices, risk exposures, and other activities so that investors and creditors can assess their condition accurately.
"Our examiners, as part of both the holding company inspection and the state member bank examination, will review and evaluate such disclosures for their conformance to best practices and their contribution to stakeholders' understanding of their risk at that organization," he said.
Market discipline is the tendency of investors or creditors to punish banks perceived as too risky by devaluing their stock and increasing their cost of debt.
Despite a recent National Bureau for Economic Research study that disputed the effectiveness of market discipline, Mr. Meyer was blunt about the impact the Fed expects market discipline to have.
"Banks will find that additional market discipline constrains their options, and supervisors will be concerned about creditors' response to bad news. But both constrained options and swift market punishment are part of the desired effect of market discipline," he said.
Last month the Fed announced that a working group of high-ranking executives from the banking and securities industries would work with regulators to identify best practices in disclosure. Mr. Meyer indicated that the group's recommendations would serve as the basis for assessing holding companies' compliance with best practices.
A spokeswoman for RMA, the Philadelphia-based credit risk management group, said the Fed's decision to evaluate their disclosure practices would have little effect on large banking companies. They were already expecting similar requirements as the result of pending changes in the Basel Accord, which sets capital requirements for large, international banking companies.
The Basel Committee on Banking Supervision is debating a proposal to update the accord, and has indicated that market discipline, with the requisite disclosure practices, will be one of three "pillars" of the new agreement.
"One thing that you can infer from this speech is that the Fed and the Office of the Comptroller of the Currency, regardless of Basel reaching a consensus, will begin regulating large, complex banking organizations in this way. They aren't going to wait for Basel, and they shouldn't," the RMA spokeswoman said.
Mr. Meyer also said that he expected banking companies' internal systems for assessing credit risk to play a growing role in setting regulatory capital. Many companies, he said, currently have advanced credit-risk-assessment systems in place. "As they improve, these systems can increasingly be expected to figure prominently in our supervisory process," Mr. Meyer said.
He warned that some companies have systems that are inadequate for use in setting capital standards and need to be updated. "Indeed, some large banks are, surprisingly, behind the curve in developing their own internal risk classifications. Their systems have too few categories, are based on insufficient historical data, have been subject to inadequate stress-testing, and are too simplistic," he said.
"I trust that these lagging banking organizations in their own self-interest will promptly revise their systems," he added.
Echoing a speech last week by Fed Vice Chairman Roger W. Ferguson Jr., Mr. Meyer said that in order for the Fed to effectively supervise financial holding companies, it might be necessary for it to have representatives on the examination teams of other banking agencies, particularly the OCC's.
The Gramm-Leach-Bliley Act, which made the Fed the umbrella regulator of financial holding companies, instructed the central bank to rely, to the extent possible, on publicly available documents and the reports of other regulators when assessing the risk of holding company affiliates.
According to Mr. Meyer, the Fed has determined that such limits are too restrictive.
"Given the systemic risk associated with the disruption of the operations of large banks - and the role of the bank within the broader banking organization - the Federal Reserve believes that it needs to know more about the activities within large insured depository institutions than can be derived from access to public information or from the reports of the primary bank supervisor."