Statement by William J. McDonough, President, Federal Reserve Bank of New York, before the Subcommittee on Financial Institutions and Consumer Credit, Committee on Banking and Financial Services, U.S. House of Representatives, March 24, 1999

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I appreciate the continued attention that you and your colleagues on the subcommittee and on the Banking Committee as a whole have brought to bear on the complex and important issues under discussion today.

The near-failure of Long-Term Capital Management (LTCM) last fall raised a number of issues regarding the activities of highly leveraged institutions. Since then, banking supervisors have been hard at work to assess where banks have been deficient in their dealings with hedge funds and other highly leveraged institutions, which I will refer to as "HLIs." This work has resulted in the issuance of supervisory guidance, both internationally and in the United States, with the aim of improving banks' policies and practices regarding HLIs.

I am happy to be appearing before you with my colleague Governor Meyer--who I understand will concentrate on discussing the Federal Reserve's policy guidance to banks regarding hedge funds--and Deputy Comptroller of the Currency Brosnan. I will focus my remarks on the work done at the international level by the Basle Committee on Banking Supervision, which issued a report and sound practice recommendations on January 28 with regard to banks' dealings with HLIs.

Before I get too far into the details, let me share with you my overall approach to the issues we will be discussing this morning. My views have been shaped not only by my positions as Chairman of the Basle Committee on Banking Supervision and President of the Federal Reserve ]Bank of New York but also by my twenty-two years of experience as a commercial banker. Both my private- and public-sector experience have led me to conclude that the LTCM episode, and the proper supervisory response to it, are fundamentally about two things: leverage and good judgment.

Leverage is an important part of our financial system. Most of the time leverage plays a positive role, resulting in greater market liquidity, greater credit availability, and a more efficient allocation of resources in our economy. But problems can arise when financial institutions go too far in extending credit to their customers and counterparties. That's where good judgment comes in.

In my view, the most important decisions a banker can make are whom to do business with and how far that business relationship should …