Market-based regulation is about to get its first big test.
Three sets of guidelines issued over the past two weeks place the onus on banks to manage the extra risk posed by lending to emerging countries and to highly leveraged hedge funds.
The regulators tackle slightly different product lines, though all recommend the same general credit-risk management practices. "There are a lot of common themes across the documents," said Stefan Walter, an assistant vice president for bank supervision at the Federal Reserve Bank of New York.
The guidelines say banks should tailor risk-management efforts to specific product and business lines, limit the amount of risk they are willing to accept, and demand comprehensive financial data on all borrowers, including hedge funds.
Regulators warned banks not to skimp on credit-risk reviews, even for fully secured loans, because collateral may be tough to liquidate during a financial crisis.
Banks must also develop new tools to measure exposures to specific borrowers. For instance, a lender should know what would happen if a hedge fund suddenly defaulted on all its obligations.
Lenders also should not enter new markets or unveil new products unless they are willing to finance the loan review, accounting, and back-office personnel necessary to keep the venture from becoming too risky.
Richard Whiting, general counsel at the Bankers Roundtable, said regulators have discovered that it is nearly impossible to restrict lending by the biggest banks, because the banks are so complex and they react to market conditions far more rapidly than in the past. "This is an intelligent recognition that banks have to harness market forces to police themselves," Mr. Whiting said.
"Regulators are creating a window of opportunity for the industry to make progress own its own," said Donald T. Vangel, a partner in the risk management and regulatory practice at Ernst & Young in New York.
"The industry would be well advised to take heed of these suggestions and develop solutions that make sense to them, rather than wait for the regulators to prescribe something more constraining."
The drive toward market-based regulation has been building since 1995, when U.S. regulators unveiled "supervision by risk," a program designed to focus examiners on the quality of a bank's internal controls versus inspecting individual transactions.
"There has been an increasing trend toward the recognition of the benefits of self-regulation," Mr. Vangel said. "You get more business- oriented solutions when you do it this way."
The latest guidance takes supervision by risk another step.
The advice issued by Office of the Comptroller of the Currency, the Basel Committee for Banking Supervision, and the Federal Reserve merely outlines best practices for managing risk. None of the guidelines detail how a bank should implement these suggestions.
"Ultimately it is bank management that is responsible," explained Mr. Walter of the New York Fed. "The regulator is merely laying out ... sound practices that it expects to see."
The three documents tackle slightly different product lines, with the OCC concentrating on derivatives trading, Basel on hedge fund loans, and the Fed on counterparty risk management.
Michael L. Brosnan, deputy comptroller for risk evaluation, said the industry should seize this opportunity to improve its risk-management efforts.
"The best scenario would be to see self-initiative from the industry," he said. "But where that doesn't take place, we will force it to. We have no tolerance for banks engaging in trading and derivatives that are not managing these risks well."
"The goal of this all is to dampen the possibility of a surprise down the road," Mr. Brosnan said.