CHICAGO The big question posed at this years premier bank policy event was how to break regulators tendency to exacerbate business cycles by backing off in boom times and cracking down when the economy slows.
What the organizers of the Federal Reserve Bank of Chicagos renowned Conference on Bank Structure and Competition really wanted to know was: How do you keep lenders from splurging when the economy is growing and closing the credit spigot in a recession?
Fed officials may be sorry they asked.
Because the mightiest tools for modulating bank lending are capital requirements, the conference morphed into an indictment of the new rules being developed by the Basel Committee on Bank Supervision.
Private-sector speakers including bankers, academics, consultants, and analysts dumped on the Basel Committees efforts, which would let the worlds most sophisticated banks develop systems for gauging the riskiness of their assets. If regulators agreed these systems worked, bankers would be able to set their own capital requirements.
Critics claimed the proposed rules are far too complicated.
In fact, Michael K. Ong, the executive vice president and chief risk officer at Credit Agricole Indosuez, questioned whether federal agencies are even up to the job of judging the banks systems.
Im very skeptical regulators will actually be able to validate the systems, he said. You regulators have three to five more years to hire some really good people.
Some background, and the regulators retort, before the bashing continues.
In 1988 the Basel Committee gave birth to the first international capital standard. It was also the dawn of risk-based supervision, which attempts to focus regulators on an institutions riskiest activities. Presumably this streamlines oversight by concentrating on a banks trouble spots.
Under the Basel Accord, the riskier a banks assets, the more capital it must hold. At least that was the idea. But bankers figured out how to game the system, so regulators decided the rules needed to be rewritten. That was five years ago, and the so-called Basel 2 rules are not expected to be in use for another five years.
Basels two leading defenders at the conference were Federal Reserve Board Chairman Alan Greenspan and Canadas Superintendent of Financial Institutions, Nicholas Le Pan.
Mr. Greenspan said Basels goal is to induce bankers to improve their risk management techniques, including how they price products, reserve for losses, and control their operations.
A broader recognition by the banking community of how important enhancing risk management is to the long-term value of the bank would effectively align the incentives of lending officers with the regulators desire for reduced cyclicality, he said.
That is a fancy way of saying regulators will not have to interfere if banks improve their own means for knowing when to rein in lenders at the top of a market cycle and when to unleash them at the bottom.
Though the Fed has been beating this drum for several years, too few banks are taking the central bank seriously. The sad fact is that the adoption of best-practice risk-management techniques has been slower than desired, Mr. Greenspan said.
In answer to a question, he noted that regulators are most interested in reining in bankers during boom times not forbearing in bad times.
Handing more ammunition to Basels critics who suspect the rule rewriting is designed simply to raise capital levels, Mr. Greenspan said that regulators want banks to build capital considerably over minimum levels in expansions as a buffer that can be drawn down in adversity.
Mr. Le Pan took a more practical approach in his presentation, ticking off the eight leading complaints about Basel 2 and then rebutted them one by one.
He scoffed at the idea that the proposal is too complex and asked how it could be otherwise if the institutions the rule governs are so complex. Only the biggest, most sophisticated financial institutions will need to read the 1,500-page rule cover to cover. It is just one of three options being proposed, he noted, and the simplest one can be described in 12 pages.
Mr. Le Pan also dismissed claims that the new rules will be too costly to implement. The best banks will need to hold less capital under the new rule, he said, and even a small reduction in capital costs can cover large expenditures to implement the needed systems.
He saved his most vehement defense for regulators plan to institute a capital charge to cover operational risk. He defiantly told the audience that the final version of the rules, expected in October 2003, will include a charge to cover the risk of bank operations.
The right answer isnt zero, he said bluntly.
Echoing other regulators at the conference, Mr. Le Pan said Basel Committee members are convinced that the rules they are writing now will be an improvement over the existing standards. While the current proposals can be criticized, what were likely to end up with is a lot better than what we have today.
The Basel Committee has been lambasted at every turn. Critics fattest target has been the plan to incorporate operational risk into capital standards, which have traditionally focused on credit risk and have recently been expanded to encompass some market risks. Operational risk is defined as the chance of loss from internal events like fraud or computer failures, or from external events like hurricanes or earthquakes.
The Basel proposal would require banks to hold 10% of gross revenues in reserve for these operational risks (versus 20% in an earlier version) or set their own level with sophisticated systems or what regulators called the advanced measurement approach.
Richard J. Herring, a co-director of the Wharton Financial Institutions Center at the University of Pennsylvania, said regulators are moving full speed ahead on the wrong track.
For one, he said, they are ignoring the most important operational risk the basic hazard of being unable to cut expenses as quickly as profits decline.
He also contended that regulators are including operational risks merely as a way to pad capital requirements. This belies any notion that they are getting to risk-adjusted regulation.
Bankers like Mr. Ong claimed that the 10% charge is arbitrary and that using the advanced approach would require big investments to build new systems, because banks do not have good data on operational losses.
But Eric Rosengren, a senior vice president at the Federal Reserve Bank of Boston, said the bankers who are collecting the data are shocked at the losses they are identifying in individual lines of business.
You cant manage what you cant measure, he said. There have been real benefits to the banks that have taken it seriously and started to collect the data.
Echoing other regulators at the conference, Mr. Rosengren urged bankers to look past specific concerns to see that Basel 2 is better overall than the current rules.
Even the capital plans most vigorous detractors conceded that critics have little chance of preventing Basel 2 from being implemented.
There is such momentum that Basel 2 will happen, said Charles Goodhart, a banking professor at the London School of Economics.
However, he predicted that regulators will never get it right. There will be a Basel 3 and maybe even a 4, 5, and 6.
