The president of the Federal Reserve Bank of New York called on international regulators Tuesday to revamp risk-based capital rules within two years.
William J. McDonough, who is also chairman of the international regulatory panel known as the Basel Committee on Banking Supervision, said "I don't think there has ever been a more urgent need ... to exercise leadership than now."
Current standards are based on a 1988 accord that predated banks' reliance on sophisticated mathematical models for calculating credit risk and on derivatives for hedging loan losses, Mr. McDonough pointed out at a conference in London sponsored by the Basel Committee.
Bankers would welcome revised capital standards, said David A. Daberko, chairman and chief executive officer National City Corp., Cleveland. "We need a much more sophisticated and realistic approach," he said.
In a letter Tuesday to the Basel Committee, the Bankers Roundtable said institutions should be allowed to set their own capital standards.
"The time has come for a new approach that relies on banks to use internal management procedures to determine the proper level of capital to be held against credit risk for capital purposes," the Roundtable said.
Mr. Daberko, who helped draft the Roundtable's letter, said current rules require banks to hold the same amount of capital for short-term and long-term loans, even though short-term loans are inherently safer. Also, the rules do not differentiate between loans to businesses with strong versus weak credit histories.
Terry Rosengarten, vice president and treasurer of First Tennessee National Corp., Memphis, said the current rules punish conservative companies like hers, which must meet the same capital requirements as banks with riskier assets.
"It is time to change," she said. "It is time for us to move more to looking at risk-based computer models."
Mr. McDonough, though lacking specifics, said rule changes must be broad enough to apply to all financial organizations, including global trading banks, nonbank conglomerates, and community banks. Yet they must be flexible enough to require that banks with risky portfolios hold more capital than those posing less risk, he said.
"Our hope is to see through the complexity of financial activity and ... identify the simple, straightforward outlines of a capital framework," the New York Fed president said in prepared remarks.
"If we can identify that framework, we can differentiate it and apply it to banks at the cutting edge of financial engineering or those new to the international markets, to banks large or small, and to nonbank institutions."
Risk-management requirements and market forces also must be factored into capital rules, Mr. McDonough said. But he rejected suggestions that regulators eliminate capital requirements and trust banks to hold enough reserves.
"We are far from being able to say that the combination of banks' internal management discipline and market discipline is so strong that capital requirements are not needed and that supervisors of internationally active banks do not need a capital accord," Mr. McDonough said.
At the London conference, Federal Reserve Board researcher John J. Mingo outlined two approaches for revamping the capital accord. One scenario would expand the existing rules to give banks more options for classifying an asset's risk; the other would use computer models to determine credit risk capital requirements.
Pressure to reform the risk-based capital system has been growing over the past several years. In June, a Federal Reserve System task force reported that internal credit risk models could eventually be used to set formal capital requirements for some assets. Last February, Mr. McDonough's New York Fed held a conference on the next generation of capital requirements.
The Basel Committee also released three reports Tuesday.
One paper summarized how 30 large, international banks handle operational risks, such as breakdowns in internal controls. The committee found that bank boards and senior managements were aware of the need to manage and measure operational risk. However, most said these systems were in their infancy and some expressed concern over the difficulty of measuring these risks.
"Experience with large losses is infrequent and many banks lack a time series of historical data on their own operational losses," the report said.
The committee also released a report calling on governments to make it easier for investors to learn the true financial health of banks. This includes timely data on financial performance, capital, liquidity, risk- management practices, accounting policies, and basic management practices.
Finally, the Basel Committee released a set of 13 principles for internal controls. These include board involvement, a focus on material risks to the bank's health, segregation of duties to avoid conflicts of interest, and comprehensive internal audits.