The Federal Reserve is quietly weighing a radical overhaul of the risk-based capital requirements it adopted eight years ago.
Four methods for measuring banks' exposure to credit, interest rate, and market risk are being studied and discussed throughout the Federal Reserve System. The aim is to make the capital rules far more sensitive to differences in the risk profiles of banks, senior Fed officials said.
The effort is still in its infancy, and a formal plan could take three to four years to emerge, these officials emphasized. But observers said the discussions now under way merit close attention.
"These would be revolutionary," said Robert W. Strand, senior economist at the American Bankers Association. "They would change the way banks are supervised and regulated."
One measure of the effort's significance is that Federal Reserve Board Chairman Alan Greenspan has taken a strong interest in the deliberations, observers said. Indeed, Mr. Greenspan kicked discussions into high gear at a Fed conference in May, when he outlined an approach to stratifying the riskiness of bank loans and allocating capital to cushion against loss.
All four approaches now under consideration could force banks with the riskiest loan and securities portfolios to hold more reserves. For banks with the least risky portfolios, that would be a welcome development. Bankers have long complained that the existing rules penalize banks that make conservative investments by requiring them to hold the same amount of capital as institutions involved in riskier assets.
"The current system is overly simplistic and not very effective for large, complex banks," Mr. Strand said.
The approaches also would give the banks much greater control over their capital by letting them use their own systems to measure exposure to credit, interest rate, and market risk. Banks would set capital reserves on the basis of the total risk faced rather than adhere to minimum ratios.
"The more sophisticated we become, the better off we will be, and the less risky the banking business will be perceived as being," said Fred Pennekamp, managing director for market risk at First Union Corp.
One approach, which the Fed is basing on recently adopted market-risk capital rules, would require banks to calculate the present value of their loan portfolios. This data would be fed into complex computer programs to produce "value-at-risk" scores, which would show the riskiness of the portfolios. Regulators would issue guidelines specifying varying capital levels depending upon the amount of risk identified by the model.
"Do we think a model-based approach to credit risk is possible? The answer is 'Yes,'" said Christine Cumming, senior vice president at the Federal Reserve Bank of New York. "The problem is finding the model that works."
The approach Mr. Greenspan outlined seven months ago in his speech to a Chicago Fed conference is similar. It would require banks to separately classify their loans into 10 categories based upon the likelihood of default. The bank would then devote enough capital to each category to ensure there is less than 0.05% chance that losses would exceed reserves.
The Fed also is experimenting with the so-called precommitment approach. Most of this work is limited to market risk - the risk a bank faces from changes in the value of its securities portfolio. Under precommitment, the bank estimates its capital requirements on the basis of its own model, but pays a fine if it underestimates its needs. Fed Governor Susan M. Phillips has said regulators could apply the same approach to managing credit risk.
The fourth and final approach, advocated by Federal Reserve Bank of New York economist Arturo Estrella, departs significantly from the other options.
Regulators would simplify the capital rules, adopting a single minimum capital requirement for each institution. Supervisors also would require banks to disclose more information about the riskiness of their loan and securities holdings. Regulators would then rely on the market to use the information to force banks to hold more capital. The theory is that investors will shun banks whose reserves do not reflect the riskiness of their portfolios.
Bankers said all the options have promise.
"All four of these ideas rely upon a principle that bank management should put in the effort to determine the appropriate amount of capital for their institution," said Garrett Glass, senior vice president and chief market risk officer at First Chicago NBD Corp. "That is good. It means the regulators are content that the industry is doing it right and carefully."
He noted that this is a natural evolution from the recently adopted market risk rules, which require large trading banks to use their own models to set capital levels for market risk.
The current risk-based capital rules require banks to hold 8% of a loan as reserves. But the rules exempt government-issued debt entirely and set a 4% reserve rate for home mortgages. The two exemptions were intended to reward banks that invested in historically less risky assets.
But regulators recently have begun tinkering with risk-based capital, adding special rules and exemptions that make compliance more expensive and difficult. For example, regulators this year have adopted market-risk and interest rate risk rules that attempt to deal with two slivers of a bank's overall capital position.
Some industry consultants worry the proposed cures may make matters even worse.
"Conceptually this all sounds very logical and reasonable," said Bert Ely, president of the industry consulting firm Ely & Co. "It appears to be a way to eliminate the capital discrimination that banks suffer from. But the problem is going to be implementation."
Mr. Strand agreed that the new approaches have shortcomings. The value- at-risk model could be much more accurate, he said. "But it will be very difficult to get examiners who are adept enough to monitor the model," he said.
Mr. Strand puts his money on an expanded pre-commitment approach, provided the fines are high enough to force banks to take the process seriously but low enough so they don't cause institutions to fail.
"If this could work, it could definitely replace the other capital standards," he said.
Ms. Cumming said all the options are still in play. Also, she said other proposals undoubtedly will emerge before the Fed acts.
"This is the time to generate lots of ideas and look them over carefully," she said. "There are a lot of interesting questions for us to be focusing on."