## Mr McDonough's statement on the work done at international level by the Basle Committee on Banking Supervision on banks' dealings with highly leveraged institutions
Statement by the President of the Federal Reserve Bank of New York, William J McDonou before the Subcommittee on Financial Institutions and Consumer Credit of the Committ Banking and Financial Services, US House of Representatives, on 24 March 1999.
Good morning Chairman Roukema and members of the Subcommittee. I appreciate the continued attention that you and your colleagues on the Subcommittee and on the B Committee as a whole have brought to bear on the complex and important issues u discussion today.
The near-failure of Long-Term Capital Management last fall raised a number of regarding the activities of highly leveraged institutions. Since then, banking super been hard at work to assess where banks have been deficient in their dealings wi funds and other highly leveraged institutions, which I will refer to as 'HLIs'. Thi resulted in the issuance of supervisory guidance, both internationally and in the Un 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 unders will concentrate on discussing the Federal Reserve's policy guidance to banks regardi funds - and Deputy Comptroller of the Currency Brosnan. I will focus my remarks o work done at the international level by the Basle Committee on Banking Supervision, issued a report and sound practice recommendations on January 28 with regard to dealings with HLIs.
Before I get too far into the details, let me share with you my overall approach to t will be discussing this morning. My views have been shaped not only by my positi Chairman of the Basle Committee on Banking Supervision and President of the Fed Reserve Bank of New York, but also by my 22 years of experience as a commercial ba Both my private and public sector experience have led me to conclude that the episode, and the proper supervisory response to it, are fundamentally about two leverage and good judgment.
Leverage is an important part of our financial system. Most of the time leverage positive role, resulting in greater market liquidity, greater credit availability efficient allocation of resources in our economy. But problems can arise when f institutions go too far in extending credit to their customers and counterparties. good judgment comes in.
In my view, the most important decisions a banker can make are whom to do business and how far that business relationship should be pursued. Those judgments are not e of our fundamental aims as supervisors should be to see that banks are using the rig make those decisions. Because banks play a pivotal role in the world economy, the imp of these decisions cannot be overestimated.
## Basle Report Findings and Guidance
## Introduction
Let me turn to the Basle Committee on Banking Supervision, which is composed of bank supervisors from the G-10 countries who develop supervisory policy for internationally ac banks. While the Committee does not have formal enforcement powers, its conclusions and recommendations are widely implemented, both in G-10 countries and many other nations. The Committee's report focuses on the relationship between banks and HLIs. Our goal was t provide a framework for identifying the broader issues raised by the LTCM episode, t policy responses of supervisors, and some key risk management challenges for the bankin industry going forward.
Because the Basle Committee's focus is on banking supervision and regulation, its prima emphasis has been on ensuring that major banks prudently manage their risk exposures HLIs. The best way to achieve this is through the adoption of sound practices by the indu It is primarily the responsibility of each banking organization to manage its risks. Bu the special role that banks play in our economy and the systemic risks that can occur they do not function properly, banks' risk management activities are a legitimate public concern. Our sound practice standards give banks and their supervisors the tools to mea industry progress toward the goal of effective risk management.
The Committee's report revealed a number of deficiencies in banks' practices. In partic the Committee observed an imbalance among the key elements of the credit risk management process, with too strong a reliance upon collateral to protect against credit losses. Th emphasis, in turn, caused many banks to neglect other critical elements of effective cred management, including in-depth credit analyses of counterparties, effective exposu measurement and management techniques, and the use of stress testing.
## The Credit Approval Process
For a bank to make sound lending decisions, it needs to obtain sufficient information the borrower. Supervisors routinely emphasize the need for banks to have an effective c approval process consisting of formal policies and procedures, accompanied by documentation of actual credit decisions. I should note that banks' credit exposure to L was in two forms: the exposure arising from the trading of financial products with LTCM, the exposure stemming from loans made to LTCM. Banks' primary exposure to LTCM was through their trading activities. Loans were not a large factor in the events that trans fall.
Regardless of whether a bank is a trading counterparty with, or a direct lender to, an must obtain comprehensive and timely financial information about that HLI's risk profile credit quality, and it must perform ongoing credit analysis of that HLI. In addition, must have a clear understanding of an HLI's operations and risk management capabilities. Committee observed weaknesses in each of these areas. Let me give a few examples.
For one, the Committee found that banks did not obtain sufficient financial informatio allow for a full assessment of how much and what types of risk had been assumed by lar HLIs. In particular, banks did not obtain the information needed to assess lever sufficiently. They did not have sufficient information to understand HLIs' concentratio particular markets and risk categories, or their exposure to broad trading strategies.
Also, banks did not sufficiently understand the ability of HLIs to manage their risk risk profiles can change from one day to the next, or even from moment to moment necessary for an HLI's counterparties to ensure that the HLI can effectively ma business operations and risks on an ongoing basis.
## Exposure Measurement
The Committee also concluded that banks should develop better measures of the exposure resulting from different types of trading activities. In particular, banks more effective measures of what is called 'potential future exposure.' Potenti exposure measures the credit exposure between a counterparty and a bank, and how exposure could change in the future as market prices fluctuate.
The ability of banks to measure potential future exposure is crucial when dealing w Unfortunately, methods for calculating potential future exposure had not kept pace growth and complexity of HLIs. As we have seen, under volatile market conditions, a exposure to HLIs can grow substantially.
In many instances, banks request HLIs to post collateral covering their exposures. H bank that does not use a realistic measurement of potential future exposure to de much collateral to require can later find its collateral holdings to be grossly ins expect the industry to develop more effective ways to measure and manage potential exposure, and supervisors will closely monitor progress to ensure that this occurs.
## Stress Testing
The Committee's report also shows that banks must develop measures that better acco credit risk under extreme market conditions. This can be achieved through what 'stress tests', where a bank conducts 'what if' analyses of how credit exposures t counterparty could grow under these market conditions. These might include a large fall in interest rates or a major change in an exchange rate.
More rigorous stress testing could have given banks at least some warning of the exposures they faced last fall. The critical importance of stress testing is noted v in our new supervisory guidance.
## Sound Practice Recommendations in the Basle Committee Report
The Basle report is accompanied by a sound practices document that sets forth an i set of standards that will guide both banks and their supervisors. Among other thi sound practices call upon banks to:
- establish clear policies governing their involvement with HLIs;
- adopt credit standards addressing the specific risks associated with HLIs;
- establish meaningful measures of potential future exposure;
- establish meaningful credit limits, incorporating the results of stress testing;
- monitor exposure on a frequent basis.
Banks generally tightened the credit risk management standards for their HLI exposur the near-collapse of LTCM. However, it is important that supervisors ensure that
continues. Memories tend to be short, and we want to make sure that as markets calm dow as they have in the past months, banks do not return to the old ways of doing business.
## Possible Future Changes in the Capital Accord
As you know, the Basle Capital Accord is one of the great successes of the Basle Committ Well before the events of last fall, the Basle Committee was developing fundamental revis to the Accord to better reflect the many changes in financial markets and risk managem practices since the Accord's creation in 1988. Among the G-10 supervisors, there is br agreement that the future Accord should make greater distinctions among a bank's cred risks. These discussions are continuing.
The strong link between sound risk management practice and the Capital Accord provides another reason for rapid adoption of the Basle Committee's sound practices. The HLI rep raises several important technical issues of relevance to the Accord. For example, Committee's call for better measures of potential future exposure may apply to the way s exposures are measured for capital purposes in the Accord.
## Other Regulatory Efforts
## Introduction
One of the Basle Committee's hopes is that its sound practice recommendations will b widely implemented by supervisors both here and overseas. Governor Meyer and Deputy Comptroller Brosnan will be discussing in detail the guidance issued by the Federal Res and the OCC. I should also note that the New York State Banking Department recently released a report on banks' hedge fund activities that supports the observations supervisory priorities set forth in the Basle Committee Report. In addition, interna supervisory bodies and supervisors from countries outside the U.S. are in the process of on many of the proposals discussed here today.
## Actions Regarding Hedge Funds by International Groups and Individual Countries
In February, IOSCO, the International Organization of Securities Commissions, establishe task force on HLIs. I understand that IOSCO is focusing on securities firms' dealing hedge funds and the ways in which risk management and market transparency can be improved, which complements the Basle Committee's work concerning banks. Because banks and securities firms are the primary counterparties of HLIs, it is crucial that the coordinated supervisory response at the international level among securities and b regulators.
At their meeting last month, the Group of Seven (G-7) countries issued a statement endor both the Basle Committee and IOSCO efforts. The G-7 intends to continue to review the top of HLIs, which will be of assistance as we urge countries to implement sound practices in area.
I would not want to characterize or opine upon the efforts of any one jurisdiction; countries' efforts, like ours, are underway only recently and need time to develop and hold. There probably will be differences in the degree to which supervisors in diff countries address the questions I have discussed today - if only because the intensity o activities varies among countries. But on the whole, I believe that supervisors in countries will follow up on the recommendations issued by the Basle Committee.
## Direct Versus Indirect Methods of Addressing HLI Safety and Soundness
Many governments have considered or will consider the advantages and disadvantage imposing direct regulation on the HLI industry. The Basle Committee report discuss issue and concluded that concentrating on the behavior of banks and other counte doing business with HLIs would yield effective and more immediate results.
A common element of many HLIs is that they are structured in ways that minimize exposure to supervisory oversight and costs. Thus, many have chosen to organize them legally in jurisdictions that offer modest supervision and low taxes.
Am I pleased that so many HLIs are organized legally in what many would characterize havens? No. But I do not think that problems involving unwise exposure to HLIs can f blamed on the fact that many of these entities are chartered offshore. To be sur diligence review that banks make for every customer should encompass the customer's of incorporation and its ramifications.
Currently, I know of no comprehensive direct regulation of hedge funds in any of countries. There are, however, aspects of hedge fund activities, such as commodi futures trading, that are subject to regulatory oversight.
I do not believe that it would be easy to develop a workable approach to the direct o hedge funds. The reality is that imposing direct regulation on hedge fund entitie chartered in the major industrialized countries would likely result in the moveme operations to sites offshore. Direct regulation of hedge funds would require a hig coordination involving the political, legislative, and judicial bodies of many count clearly beyond the jurisdiction of most banking supervisors.
As bank supervisors, we have opted for a strategy that will, I believe, bring subst term results. Our approach to improving the financial system's interactions with H focus quickly and aggressively on the decisions by banks that could create excessive or imprudent credit exposure. Perhaps our strategy can be termed 'indirect', b reasonably confident that it will succeed.
## Conclusion
Chairman Roukema, I thank you and your colleagues for the opportunity to explain about the international efforts that address financial institutions' dealings with promised quick and decisive action on the events that were so fresh in our minds testified before you and other members of the House Banking Committee last fall. I h agree that we have made real progress at the Basle Committee level and in the sup developments you will hear about in Governor Meyer's and Deputy Comptroller Brosna testimony.