Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Role of Capital in Optimal Banking Supervision and Regulation

Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Role of Capital in Optimal Banking Supervision and Regulation

Article excerpt

It is my pleasure to join President McDonough and our colleagues from the Bank of Japan and the Bank of England in hosting this timely conference. Capital, of course, is a topic of never-ending importance to bankers and their counterparties, not to mention the regulators and central bankers whose job it is to oversee the stability of the financial system. Moreover, this conference comes at a most critical and opportune time. As you are aware, the current structure of regulatory bank capital standards is under the most intense scrutiny since the deliberations leading to the watershed Basle Accord of 1988 and the Federal Deposit Insurance Corporation Improvement Act of 1991.

In this tenth anniversary year of the Accord, its architects can look back with pride at the role played by the regulation in reversing the decades-long decline in bank capital cushions. At the time that the Accord was drafted, the use of differential risk weights to distinguish among broad asset categories represented a truly innovative and, I believe, effective approach to formulating prudential regulations. The risk-based capital rules also set the stage for the emergence of more general risk-based policies within the supervisory process.

Of course, the focus of this conference is on the future of prudential capital standards. In our deliberations, we must therefore take note that observers both within the regulatory agencies and in the banking industry itself are raising warning flags about the current standard. These concerns pertain to the rapid technological, financial, and institutional changes that are rendering the regulatory capital framework less effectual, if it is not on the verge of becoming outmoded, with respect to our largest, most complex banking organizations. In particular, it is argued that the heightened complexity of these large banks' risk-taking activities, along with the expanding scope of regulatory capital arbitrage, may cause capital ratios as calculated under the existing rules to become increasingly misleading.

I, too, share these concerns. In my remarks this evening, however, I would like to step back from the technical discourse of the conference's sessions and place these concerns within their broad historical and policy contexts. Specifically, I would like to highlight the evolutionary nature of capital regulation and then discuss the policy concerns that have arisen with respect to the current capital structure. I will end with some suggestions regarding basic principles for assessing possible future changes to our system of prudential supervision and regulation.

To begin, financial innovation is nothing new, and the rapidity of financial evolution is itself a relative concept--what is "rapid" must be judged in the context of the degree of development of the economic and banking structure. Prior to World War II, banks in this country did not make commercial real estate mortgages or auto loans. Prior to the 1960s, securitization, as an alternative to the traditional "buy and hold" strategy of commercial banks, did not exist. Now banks have expanded their securitization activities well beyond the mortgage programs of the 1970s and 1980s to include almost all asset types, including corporate loans. And most recently, credit derivatives have been added to the growing list of financial products. Many of these products, which would have been perceived as too risky for banks in earlier periods, are now judged to be safe owing to today's more sophisticated risk measurement and containment systems. Both banking and regulation are continuously evolving disciplines, with the latter, of course, continuously adjusting to the former.

Technological advances in computers and in telecommunications, together with theoretical advances--principally in option-pricing models--have contributed to this proliferation of ever more complex financial products. The increased product complexity, in turn, is often cited as the primary reason that the Basle standard is in need of periodic restructuring. …

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