William J. McDonough, president of the Federal Reserve Bank of New York, called Wednesday for a sweeping overhaul of the bank regulatory system, saying governments should focus more on global stability and less on deposit insurance.
"The future of supervision will be about ensuring the stability of all financial institutions" that have the potential to destabilize the world's or a nation's finances, he said.
Addressing the Institute of International Bankers, Mr. McDonough zeroed in on the threats global financial institutions pose to the economy. He called for appointing a single agency to serve as the regulator of these institutions, which offer banking, insurance, and securities products.
"All global financial conglomerates large enough to potentially threaten the stability of the financial system should, at minimum, be subject to some form of consolidated oversight that has market stability as its guiding principle," he said.
Mr. McDonough called for consolidated supervision of banking, securities, and insurance companies, plus new international capital rules and accounting standards.
"Protecting the deposit insurance fund will not be the primary objective of supervision in the future," he said. "There is a growing realization that our approach to deposit insurance needs to be reconsidered so as to minimize the potential for moral hazard and to focus only on those small depositors that truly require protection."
Regulators and auditors also need to refine risk-based supervision, he said. They should first assess whether the overall internal control system is appropriate for a bank's business plan. Then they should focus on risks that pose the greatest threat to the company's health, he said.
"Institutions that demonstrate sound risk-management ... should be subject to less intrusive supervision than institutions that do not have this essential infrastructure in place," he said.
Reforming capital requirements is essential to regulatory reform, he said. "We need to begin thinking now about a comprehensive framework for the next generation of capital rules-particularly given the long lead times involved," he said.
Regulators must incorporate legal, operational, computer, and portfolio concentration risks into revised capital standards, he said. One solution would be to rely on internal models to set capital requirements for these additional risks, he said.
He also recommended subjecting financial conglomerates to a single set of capital requirements. This would make it easier for regulators worldwide to assess the health of these companies, he said.
Bank directors and managers also must bear greater responsibility for ensuring the health of their institutions, he said. "While a sound capital adequacy framework is essential to financial market stability, it must be complemented by effective management at the firm level, by market discipline, and by meaningful official supervision," he said.
Many of the recent financial scandals, such as those involving Daiwa Bank and Barings Bank, could have been avoided if executives focused more on risk-management and less on profits, he said.
"If the board of directors and senior management clearly are interested excessively in profits and chose to pretend profits do not involve risk, then that institution is in grave peril," he said.
He also issued a blunt warning to banks the do become embroiled in trouble. "Not telling us what is going on is the ultimate no-no," he said. "If you don't tell us, we will be part of your next problem."
Banks should demand that the accounting industry adopt worldwide standards for auditing financial statements, he said. This is the only way to ensure institutions are actually healthy rather than hiding loses in their books.
The industry also should disclose more about its securities trading and use of derivatives, he said, although he did not comment on a controversial Financial Accounting Standards Board plan requiring firms to include derivatives on their quarterly income statements.
"Time and again experience has shown that in times of stress, insufficient information about asset quality can lead to rumors and overreaction in the market place," he said.
His message was well received by the more than 100 industry officials in attendance. "Mr. McDonough put forth a very positive, forward-looking approach to the supervision of financial institutions," said Lawrence R. Uhlick, executive director of the Institute of International Bankers.
Paul W. Huyer, vice president for finance and operations at Toronto Dominion Bank, said he agrees with the call for better capital rules. "He was right in looking at it more from a modeling point of view," Mr. Huyer said. "That is really important."
But Yves Pire, first vice president at Union Europeenne de CIC, said change was not possible until Congress passes financial reform legislation. "Until you break the Glass-Steagall Act, this will be a side issue," Mr. Pire said.