Academic journal article Economic Commentary (Cleveland)

Evolution in Banking Supervision

Academic journal article Economic Commentary (Cleveland)

Evolution in Banking Supervision

Article excerpt

Banking supervision must keep pace with technical innovations in the banking industry. The international Basel Committee on Banking Supervision currently is reviewing public comments on its proposed new method for judging whether a bank maintains enough capital to absorb unexpected losses. This Economic Commentary explains how existing standards became obsolete and describes the new plan.

It's no secret that the banking business has been changing rapidly. Computer, telecommunications, and satellite technologies have opened avenues for intermediation and risk management that were inconceivable as recently as 25 years ago. Moreover, whether independently or because of pressures created by technical change, a worldwide movement toward less restrictive financial regulation has been at work.1 Global banking and financial markets have flourished as barriers to the free flow of capital and goods and services have fallen around the world. In the United States, mergers of large into ever-larger banking organizations have accompanied the elimination of legal barriers to nationwide branching. Combinations of banking, securities, and insurance businesses were emerging even before recent financial modernization legislation clarified the relaxation of regulatory restraints.

Banking supervision has been adapting to these vast structural changes both in the United States and abroad. Traditionally, supervision of safety and soundness relied on bank examiners to test the quality of a bank's assets and, indirectly, its asset selection process. Examiners' reports formed the basis for a supervisory judgment about the adequacy of a bank's capital for absorbing potential unexpected losses. Like banking, however, supervisory techniques are changing around the world. Last year, the worldwide Basel Committee on Banking Supervision, operating under the auspices of the Bank for International Settlements, published proposals for a new supervisory capital-adequacy framework that would supercede its widely adopted 1988 capital accord. This Economic Commentary describes the major innovations in the new Basel Committee proposals, placing them in the context of changing banking and supervisory technology. Before doing that, it will be helpful first to consider why supervision is necessary at all and then why the 1988 Basel capital accord is said to be "in tatters."

Why Regulate and Supervise Banks?

No one should have a more intense concern for both the profits and safety of a bank than its own shareholders. That being the case, how can nonmarket governmental supervisors be any better at evaluating a complex banking organization's risk exposures and need for capital than the managers of that organization itself?

One reason why banking regulation and supervision are necessary is to redress "moral hazard." In most countries, banks are protected by government safety nets, typically including a lender-of-last-resort facility and/or deposit insurance. Safety nets can produce suboptimal market results by inflating banks' incentives to take risk. Banking regulation and supervision must replace the market discipline removed by the safety net.

A second rationale-at least in the case of Federal Reserve banking supervision-is that a Reserve bank carries on a banking business, requiring careful attention to its own counterparty risk exposures. Each business day banks in this country make about $1 trillion in payments to one another. A substantial share of these involve near-instantaneous, irrevocable wire transfers of funds by the Reserve banks for their banking customers. In order to fund the wire transfers, the Reserve banks extend something like $100 billion of daylight credit. They must manage their resulting risk exposure to protect themselves from any loss that would result if a customer bank were to fail without having repaid its daylight borrowing. Managing this exposure involves monitoring the credit quality of their customer banks and supervising their adherence to capitaladequacy requirements. …

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