Magazine article American Banker

Financial Institutions Are Recognizing Benefits of Aggressive Self Regulation

Magazine article American Banker

Financial Institutions Are Recognizing Benefits of Aggressive Self Regulation

Article excerpt

While supervision is vital and necessary, Ernst & Young's Donald Vangel says that greater self regulation is helped through-not driven by-advances in risk management technology.

From Donald T. Vangel's perspective, the movement toward risk-based supervision reflects fundamental changes to the landscape of financial risk management. He ought to know; prior to becoming a partner in Ernst & Young's risk management and regulatory practice group this past summer, Vangel was a 17-year veteran of the Federal Reserve Bank of New York, where he served most recently as senior vice president responsible for oversight of domestic banks and the U.S. operations of foreign banks.

MS: What was your experience at the Federal Reserve Bank with regard to changes in risk management?

VANGEL: Clearly, supervisors recognize that the old fashioned, backward-looking approach to supervision is not particularly relevant to (the financial) industry, the dynamics of which suggest that the risk profile could change in a nanosecond. Historically, supervisors focused on scrubbing the loan book, where things didn't tend to happen quite so cataclysmically. But (they) really relied overall in terms of their assessment on the financial performance of the firm. That's not to say that they weren't looking at controls and risk management, but I would characterize the approach of examiners as (not) drilling down too deeply in terms of really testing transactions from cradle to grave to see how controls and risk management really worked. Or looking at models and the controls around them to get a handle on the integrity and robustness of risk management information. That's changed over the last couple of years.

MS: What drove the progression of supervision and how did it manifest itself in the financial industry?

VANGEL: A recognition-events such as Barings and Daiwa cemented it, but it was in train before that-that the dynamics of the business were changing. Toward the late '80s, the traditional approach really held sway. And, of course, the problems of the late '80s and early '90s were old fashioned credit cycle problems. Those occupied the supervisors' time fairly extensively. Many name institutions were struggling through that period Things like capital and reserves started really having meaning to the industry in ways that they didn't before.

As that problem was worked through and the supervisory committee took something of a breath because credit underwriting standards, reserves, and capital improved so substantially, the focus shifted toward the more dynamic aspects of the business: trading and capital markets activities and the management processes around risk. It's the nature of the supervisory business that you're never comfortable. You're trying to anticipate the next problem. Not that this wasn't happening in the early '90s; the Federal Reserve's examiners' trading manual came out in '93. The focus became risk management. And that's been and still is an evolving process. MS: What is the intent of risk-based supervision?

VANGEL: What risk-based supervision really means is kind of a fluid concept. I define it as an approach to the examination that seeks to identify-with a lot of upfront analysis and discussions with management auditors, internal and external-the core risks of particular businesses that an institution is in, and then goes through a process which makes selection of which of those risks are material enough to warrant a real focused, on-site effort at the examination.

What that means is looking at businesses as opposed to looking at products. So you start blurring legal entity distinctions a little bit, but I think it's the only way to look at risk. Worrying about the management processes and controls surrounding that business and using supervisory resources much more selectively to focus on where you're likely to get the most bang for the buck in terms of insight into the real quality of the operation, and therefore, into the future prospects of the operation. …

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