Financial Update (April-June 1996)
Bank Supervisors, Banking Industry
Must Re-evaluate Regulatory Strategy
As banking evolves into a more complex and dynamic industry, traditional regulatory techniques also must be re-examined and banking supervisors must remain open-minded about finding better and more efficient ways to do their jobs. The result might be an eclectic approach to ensuring that financial markets remain sound. That was the message Atlanta Fed President Jack Guynn offered to bankers and business leaders at the Atlanta Fed's Financial Markets Conference in Coral Gables, Fla., on Feb. 22. The following are excerpts from his speech.
Although the old paradigm of regulation worked fairly well in a more stable world, it's no longer completely suitable in today's more dynamic world. As financial markets have become marked by rapid change and uncertainty, we can't just update the parts of our regulatory approach that are essentially fixed or static; even capital-based procedures fall into this category.
Best policy approaches
We—not only bank regulators or financial regulators but firms in the industry as well—we must open our minds to new ways of achieving our ongoing goals. Together, we must find the best public policy approaches for today's financial markets—approaches that will promote efficiency, flexibility, and innovation while still keeping the overall financial system safe and sound.
From static to dynamic
President and CEO of the Atlanta Fed
There was a time when examiners focused on verifying assets and measuring potential credit losses at the time of an exam. This snapshot approach often worked satisfactorily in an environment that was marked by a fair degree of certainty. We have learned that static measures of risk and capital have become less relevant in this era of dynamic financial markets. Therefore, we've moved toward analyzing the risk-management process at banks rather than trying to identify risks. As we evolve, we're moving fastest on those parts of banks that deal in tradable securities.
The internal models proposal for assessing market risk in trading accounts exemplifies the regulatory evolution. Banks with active trading accounts already have risk-management models that calculate value at risk. Bank regulators' internal models approach, adopted late last year for implementation over the next several years, seeks to take advantage of banks' models to determine appropriate risk-based capital set-asides.
Other new ideas
The internal models approach has been an important shift for the Fed (and other regulatory authorities abroad). Nonetheless, I hope we can progress beyond it. There are a few ideas that have already been talked about that might prove to be useful in regulating trading risk. One idea is called the precommitment approach. It would allow a bank to specify its maximum expected trading loss over a given period and to set aside an amount of capital based on this loss. Trading losses exceeding the bank's specified loss would subject the bank to prespecified penalties. The bank would thus have a clear incentive to limit its trading losses. Regulators wouldn't dictate the modeling methodologies that underlie the precommitment levels. Supervisors would, however, review the models. This method has a number of potential advantages. The main one is that, properly designed, it would move to align a bank's incentives with regulatory goals. Variations of this approach might be used in other regulatory situations.
Incentives-based approaches have their limits as well. Markets differ in liquidity. Consequently, they also differ in their capabilities to provide independent checks on prices and to allow for trading to avoid risk exposures. When performance or valuation information is likely to be tenuous, procedural regulation might continue to be more appropriate.
I think we'll need to keep a range of regulatory approaches. Traditional approaches may be suited to situations where practices need to be controlled in advance. The Barings case immediately comes to mind as an example of a situation in which effective regulatory encouragement of stronger internal controls might have made a difference.
On the whole, I believe that regulation based on incentives applied in appropriate situations warrants further study and debate. If regulators can find effective ways to focus on the results of banks' decisions on risks, then banks should have greater incentives to control risks and less incentive to find ways around regulations.
Open to new ideas
I'm challenged to evolve my thinking as a regulator rather than to remain static. At the same time, I challenge others to help formulate approaches to regulation that will keep our financial markets vibrant yet safe, innovative yet sound.