Regulators may rejigger current risk-based capital requirements, allowing banks to customize reserves for their riskiest assets, Federal Reserve Board Chairman Alan Greenspan said Thursday.
In a speech here, Mr. Greenspan said regulators are going into the major banks to see how capital is allocated to cover credit risk. These internal models, he said, may be a more accurate means of determining how much money is needed to protect banks from loan losses than the basic risk-based capital calculation.
"The weaknesses in the risk-based capital structure have become ever more evident," he told the Federal Reserve Bank of Chicago's annual bank structure conference.
"These capital allocations are for internal management, not regulatory purposes, but I am impressed by what they teach us and what they imply for regulatory capital."
Mr. Greenspan stressed that regulators are just beginning to explore this idea; the agencies are not close to releasing a proposal for comment. But the Fed chairman's announcement does represent a renewed interest in credit risk and puts the industry on notice that the eight-year-old risk- based capital standards are ripe for revamping.
In 1988, regulators from around the world agreed to slot various bank assets into different risk categories. The riskiest assets, namely loans, required the most capital, 8% of a bank's assets.
Mr. Greenspan complained that the 8% figure often has no relationship to the bank's actual exposure and can fool the public into believing an institution is stronger than it is.
Recognizing this fault, some banks have created their own risk-based capital systems that rate each loan from 1 to 10, with 1 representing a AAA asset and 10 signifying a loan that is about to be written off.
The banks then use historical data on the performance of loans in each of the 10 categories to come up with an average loss rate. Finally, the banks use the loss rate to set capital reserves, putting away enough money to be 99.5% certain that expected losses are covered.
In keeping with the risk-management theme of the conference, Mr. Greenspan said the New York Clearing House Association is organizing a study on a new approach to market risk, or the risk a bank's trading activities face from changes in interest rates.
The New York Clearing House will test the Fed's so-called precommitment approach to market risk, which allows banks to reserve a specific sum of cash to cover swings in a trading instrument's value. Under the Fed plan, a bank would be fined if the swing in value exceeded the amount reserved.
"This methodology would provide market and other financial incentives for banks to choose capital allocations that are consistent with their own risk management capabilities, as well as with regulatory objectives," Mr. Greenspan explained.
The precommitment model is an alternative to the market-risk approach taken by the Basel Committee. That system, which the agencies are in the process of implementing, requires banks to base capital reserves on the results of complex computer programs that seek to predict how the portfolio will react to interest rate changes.
Later in the conference, Huntington National Bank chairman W. Lee Hoskins warned regulators that the banking industry can't tolerate too much more regulation.
"If the regulatory environment is as stifling as I think it is going to be, then banks need to give up their banking charters and the regulators that go with them," said the former president of the Federal Reserve Bank of Cleveland.
Mr. Hoskins added that the Fed would be much more successful in stopping bank failures and systemic crises if it maintained a stable monetary policy with near zero inflation.
Answering questions after his speech, Mr. Greenspan said the Fed's current procedures for reviewing the competitive effects of mergers are flawed, relying on overly simplified economic models of competition in different markets. But Mr. Greenspan said the Fed must be careful when deciding how to change the system because so many mergers are negotiated on the basis on the existing regulatory structure.
The chairman also said he believes small-business financing will remain plentiful during the coming years, even if banks continue to merge. "Even though we have had considerable consolidation to date, it has not shown up as a constraint on small-business lending," he said.
Finally, Mr. Greenspan said he sees little difference between electronic money and the currency banks issued prior to the 1860s. He said regulators should not impose rules on electronic money unless they would have imposed the same restrictions on the banks that issued cash.