## Mr. McDonough's address on the occasion of the 10th International Conference
of Banking Supervisors Keynote address by Mr. William J. McDonough, President of the Feder Reserve Bank of New York and Chairman of the Basle Committee on Banking Supervision, on t occasion of the 10th International Conference of Banking Supervisors held in Sydney on 22/1
I am very honored to be here as Chairman of the Basle Committee on Bankin Supervision and as the Chairman of this year's International Conference of Banking Super These are unusually difficult and challenging times for bank supervisors around the Turbulence in the financial markets has touched the banking system in virtually every co varying degrees and in many different contexts, bank supervisors are dealing with adjust their banking systems to assure their strength and vitality.
At times like these, bank supervisors have a special role in maintaining f stability. That role is to facilitate a resolution of banking problems so that the deposit will continue to provide the vital lifeline of credit to businesses and consumers. Past e many countries suggests that even severe problems can be overcome with decisive action by to identify problems quickly, recognize losses, strengthen the capital base, and execut forward-looking business strategy.
Today, the supervisory community has the same challenge. We must identify t lessons to be learned from the current financial turmoil and address them. Moreover, we mu even while there is continued rapid evolution of financial markets, products and strategi constant challenge that evolution poses to our existing supervisory policies and techniq the challenge of evolutionary financial markets is clear in countries with financial insti are actively involved in the international marketplace, it is no less important for emer countries, which increasingly feel the influence of international financial competition.
Thus, it is appropriate that we are devoting a day to questions of operationa area of rapid evolution in risk management concepts and practice. The most important operational risk problem, that of preparing for the century date change in the Year 20 prominent place on the program and in our national supervisory agendas. I congratulate o the Reserve Bank of Australia, working in cooperation with the Australian Prudential Reg Authority, for putting together this program and I thank them for hosting the ICBS this yea
I would like to focus on the dual role of supervisors in preventing banking p and in providing the necessary support when there are systemic problems. When the Committee, in concert with banking supervisors from around the globe, developed and in finalized the Core Principles for Effective Banking Supervision, it was with this dua supervisors in mind. On the prevention side, our primary goal as supervisors should be to risk of severe problems to the lowest possible level consistent with adequate provision o the economy and a sense of two-way risk for banking institutions. Quite correctly, most of Principles are aimed at the task of reducing the potential for systemic problems. However, vitally important that when problems arise for an individual institution or a group of supervisors can provide guidance and supervisory action, as necessary, to resolve the situa some Core Principles, especially those on supervisory enforcement and the safety net, ad operational role of supervisors and the institutional context in which they carry out that
All of us have learned a lot about marketplace turmoil and systemic risk in year to 18 months. First, I will highlight some issues reflecting the close linkages bet liquidity and capital adequacy, both at the financial firm and the market level. Next, I lessons from earlier experiences with banking problems and show how prompt, but delib
responses to credit problems can improve the health and liquidity of the banking syste conclude by talking about the work of the Basle Committee, both with respect to the im problems and the future agenda.
## II. Preventing Financial Problems
The market disturbances of the past 18 months have focused a great deal of att on the need for greater transparency and for increased attention to corporate governance, accounting matters, without diminishing the traditional supervisory focus on credit, liq capital.
Recent events suggest that we are seeing new ways in which the links between c and liquidity are increased in the financial system. Wider credit spreads in virtually traded financial markets, accompanied by declines in liquidity in many markets, signal us concerns are rising in the financial system. We, as supervisors, must interpret and respo signals, often in shorter time frames than we are comfortable with, and often in concert level of market volatility. One anomaly is that these issues arise in the face of appare improvements in liquidity in the high-yield bond, syndicated loan, and emerging markets have seen at various times since the early 1990s.
Four questions about the current developments appear to offer well-defined av which supervisors can pursue.
First, are current market conditions signaling a loss of confidence in pri judgments, perhaps in response to the growing awareness of how capital mark instruments, especially derivatives, can transform the risk profile of custo counterparties?
Second, are growing capital market activities involving credit risk, such as e corporate debt underwriting, foreign exchange and credit derivatives, securitization creating new liquidity stresses, in particular, greater liquid financial institutions and their customers, when credit quality declines?
Third, to what extent are markets signaling greater uncertainty about the nat level of risks in the world economy given the tremendous structural change world financial system and the world economy over the last two decades?
Fourth, what do recent market developments tell us about the capacity of fin firms to define and manage risk, or to fully understand their own risk profile?
The question of what current market conditions may be signaling about confiden prior credit judgments is especially important for supervisors. For example, do superviso revise what they expect banks to know about their customers, their business strategies business purpose of their transactions? In the run-up to the recent market problems, we customers make use of innovations in financial products and strategies developed since 1980s to a much greater extent than before. For example, banks, corporations and governm the emerging markets world are far more involved in foreign currency funding, derivatives and use of the international capital markets for debt issuance than before. New groups of i customers, such as hedge funds, are devoted almost exclusively to developing and exe strategies based on innovative financial instruments and techniques.
The basic financial analysis that is the foundation of the credit process affected by changes in both customer and counterparty behavior. For example, a lesson w learned from the current turmoil is how complex the concept of leverage is in today's where leverage roughly describes the ratio of risk to capital. Where leverage once could be directly from the balance sheet, we've become aware that leverage can be achieved in a nu ways. These include holding a high-risk portfolio of assets, engaging in extensive derivati especially if it involves options, funding domestic currency assets with foreign currency investing in long-term assets with short-dated funding and pursuing a high-risk business st of these effectively can create leverage.
A related lesson learned is that collateral can mitigate credit risk, but eliminate it. One reason is that posted collateral inevitably lags movements in market recognition of credit issues. In trading agreements, for example, gaps between the amount the customer and the amount of collateral pledged develop surprisingly quickly. One costly is to hold large amounts of excess collateral, but that is most often unacceptable to the Similarly, when the collateral is real estate, equities or high-yield securities, a gap between the amount owed and the value of the collateral whenever the price of the co declines. We have seen both problems in the current turmoil.
These questions of credit analysis and risk control are an integral part of t work of the Basle Committee on credit risk management. The starting point for that work is describing the framework for traditional credit risk management by banks. That framework c be used to consider how changes in the financial markets affect the credit process. In add issues I've described, this work will look at the impact of other developments such as models, credit derivatives and securitization. One goal of this work is to identify a management which are improving, and those which may need strengthening, especially pote problems in the internal controls that prevent and detect breakdowns in risk control.
The second question, how the larger role of capital markets activities is liquidity risk, also involves a reconsideration of the guidance the Basle Committee de decade ago. The recent market turmoil has been especially hard on emerging market banks funded domestic currency assets with unhedged foreign currency liabilities. The liquidit concentrations on the asset side of the balance sheet has a different significance when as not only to raise cash but also to conduct portfolio management, which assumes generall markets. Moreover, we are seeing new liquidity needs arising from the changed funding prac customers. For example, we are seeing instances of customers who had funded themselves lar the capital markets in recent years turning to the banking system for funding in the curre environment. These observations and issues, which also have been made by others, most recen Willard Group, have led us to add liquidity management to the near-term agenda of the Committee.
The third question involved the role that uncertainty as a result of structura the financial system may be playing in recent market developments. One lesson from this tu how difficult it is to understand the linkages between markets and economies in light of th patterns of financial and economic flows.
In the near term, this points to the need to incorporate more guidance on mea stress testing into our supervisory policies and devote more attention to it in our supervi For meaningful stress testing, a bank must have strong information systems that can both
information about the bank's positions and facilitate analysis of the positions unde scenarios. Better management information systems is one of the primary benefits of the move greater modeling of market and credit risk management. Management information syste however, are not enough. It also is necessary for management to assess the internal and factors that create risk in relation to the bank's positions in order to come up with re scenarios. And finally, a bank needs a process to ensure that the results of stress tes high-level attention necessary for the bank to respond effectively to the results.
In the near term, supervisors also must re-examine how they think ab concentrations. One lesson from the recent turmoil is how correlations in market prices previously unsuspected linkages: countries with similar government debt structures or exchange rate regimes, institutional investors with similar risk strategies, and instru with widely different customers, but with a common element of market risk, such as a c related risk. Stress testing also can be useful in identifying such concentrations, part accompanied by thoughtful analysis from bank management.
These issues will be addressed in the ongoing work of the Committee on credit liquidity risk management. In two other areas, we have begun work, but the magnitude of th will involve more time.
The first area is capital. The added focus on stress testing by banks supervisors should also influence how supervisors evaluate capital adequacy at banks. As b developing risk management and stress testing approaches, some are beginning to look at h determine whether their capital is adequate to absorb losses, including losses under reaso scenarios. One lesson from the current environment is the enormous size of market movement are possible in such a stress scenario-whether in currency or equity markets or in credi and how quickly losses from even small positions can mount. As banks develop new method evaluating capital adequacy, we can consider whether these approaches provide new too assessing capital adequacy from a supervisory perspective.
The second area is transparency. The challenge of understanding the impac changes in the financial system on banks and financial markets should add impetus to our increase transparency in the financial markets. As understanding the nature of the borrow risks becomes more complex, the demand for better and more timely information is incre Moreover, we supervisors have a special interest in putting good information in the investors, lenders and counterparties, and that is the powerful assistance that market di provide supervisors. We have seen how a bank's equity price, its funding spreads and its markets can provide feedback on the bank's prospects, and how these market signals can decisive factor in motivating management to address problems. We also have seen through c events how the absence of sufficient information can mask critical weakness in the corpo banking sectors, leading initially to an over-optimism that is followed by excessive risk a
The Basle Committee has created two working groups, the Transparency Subgroup led by Susan Krause of the Office of the Comptroller of the Currency, and the Accountin Force, led by Nick LePan, of the Office of Supervision of Financial Institutions in Canada, ways in which banks, bank supervisors, the accounting community and others can fu transparency.
I have described several issues and spoken mainly about areas for addit supervisory guidance. But as we consider the issues of credit, liquidity and capital rais
market developments, we should look at the full range of tools that supervisors have at the to help prevent financial problems. They include:
licensing, which ensures that banks are owned and managed by people with integ and appropriate expertise and that activities they engage in are limited deemed appropriate for banks;
prudential regulation, which sets standards to ensure the prudent operation of best-practice guidance, which allows banks to benefit from the supervi knowledge of superior industry practices;
on and off-site supervision, which allows supervisors to review banks' opera procedures and records for the purpose of evaluating compliance with l prudential standards and other safe and sound banking practices, as well as t the risk inherent in banks' entire operations;
accounting and disclosure standards, which ensure that investors have an ac picture of banks' financial condition; and enforcement powers, which allow supervisors to take action to correct viola address overly risky practices and resolve problem situations.
## III. Resolving Financial Problems
The immediate problem for many banking supervisors is to address the problems credit, liquidity and capital adequacy in their national banking systems. Banking superviso important role to play in encouraging a rapid but deliberate recovery of asset quality at it is still too early to look at lessons learned about resolving such problems from t banking difficulties, we can draw on the lessons of the past.
The 1980s and early 1990s offer examples of what can be done to resolve bank problems. For example, the United States suffered oil and agriculture-related regional re the 1980s and a real-estate and leveraged buyout-led recession in the early 1990s. Severe related problems developed around the same time in many European countries, with se repercussions for some banking systems. Today, banks in most of these countries are much s and until recently, highly profitable. What happened?
I would like to suggest five steps that form a common theme in the more succe recoveries. First, banks, often with the assistance of their supervisors, ascertain dimensions of their credit problems. The result of the process was realistic assessments of a total of actual losses in the portfolio that needed to be charged off;
the potential additional losses, both in a 'most likely' and 'worst case' scena the exposures that needed to be considered in 'workout' mode. The workout lo were those which had sufficiently severe problems that it was time to stop v them as 'business as usual', but to see them as requiring special attention.
Second, the workout loans or exposures were assigned to the special experti workout specialists. Banks built their own staffs or outsourced the activity to anothe institution, a consulting firm or a boutique. In the early 1990s, some banks took an even m step and sold the loans to firms that specialized in managing distressed debt. The key, ho to get these exposures in the hands of those who could work with borrowers or the mar maximize the value from problem portfolios.
The workout process must not be allowed to interfere with the continued provis credit to the economy, however. The key policy concern in the early 1990s in the Unite shifted quickly from worries about bad banks to a credit crunch as banks aggressively tac loan problems. And that is why it is so important to segregate the 'workout' portfolio remaining loan portfolio. When a dedicated staff is working out bad loans, the bank's of devote their attention to the continued sound operation of the bank-the current agenda o the bank's customers well and the forward agenda of developing and executing a sound bu strategy.
This is a key reason every country needs a strong legal framework for c relationships and a robust bankruptcy process. Successful workouts cannot occur if the responsibilities of creditor and debtor are not clear, and especially if there are n processes that can be used as a fallback and discipline on debtors if all other means of exhausted.
Third, the banks assessed the consequence of identified and potential losses loan loss reserves. The Basle Committee has just this month published guidance on the valu loans and loan loss provisioning. It urges that loan impairment be recognized promptly, tha reserves reflect the potential for loss in the credit portfolio, and that adequate disclos quality, loan loss provisioning and loans losses be made.
Fourth, banks, often with the help of supervisors, assessed the adequacy o current and prospective capital levels in light of the loan losses identified and the loan estimates reflected in the reserves. In most cases, this meant a need for additional capita raising capital funds directly from the market or from existing shareholders, or by con merger or sale of all or some of the bank.
This issue of raising capital when the bank is under stress is one of the most questions for bank management and for supervisors, but our collective experience sugges solutions can be found even in very difficult markets. The key to success appears to b disclosure of the existing problems, an action plan to address the problem, and a viabl strategy going forward. We know from experience that when a bank takes these steps, curr potential investors are far more likely to react positively. Indeed, there is a we community of investors seeking bargains among distressed institutions with decent prosp recovery.
When banks turned to shareholders or the marketplace to raise new capital, the were confronted with concerns about market perception, dilution of existing shareholders, loss of control by the current owners, and reduction of prices of existing equity and debt. and are valid issues, but again, judging from experience, they proved to be secondary to issue of ultimate recovery or resolution of the bank.
The enlightened self-interest of the management of a troubled bank usually al to see what needs to be done and to take appropriate action. If not, supervisors must have to step up the pressure through statutory enforcement powers. While the pressure initial informal and private, in the form of supervisory letters or similar instruments, it must b move to more formal types of agreements with the board of directors of a troubled b institution.
Fifth, bank management and supervisors resolved troubled banking institution the first instance, this meant understanding and helping bank boards of directors to under the options were for realizing value from the institution. Even for a bank losing substant of money, there may be aspects that represent valuable customer franchises or the oppor enter a new market or the ability to consolidate operations and increase operating lever are assets for which there is a market-and a market price. Realizing the value from the while winding down the less viable aspects of the business may be one way for the bank manage its own market exit.
As a second line of approach, banking supervisors had resolution procedures an necessary statutory powers to take over failing banks and resolve them. This almost always the need for additional capital and funding. In many cases, the banking agency or depos could sell off deposits and other elements of the franchise in such a way that continuo could be offered to customers. Since the banking agency or insurer often was left with the workout expertise was required to realize value from them.
Throughout these steps, supervisors need to work with troubled banks i constructive manner, just as banks should deal with troubled customers. If the supervisory too harsh, the supervisor will exacerbate the stresses on credit and liquidity in the fin Bank supervisors must have the tools and the determination to make steady progress in t recovery or to seek resolution through merger, sale or the winddown of the bank. The pr workout may be deliberate and patient, but it must move forward as quickly as practicable a permitted to stall. Only then can the normal flow of credit and liquidity in the financi maintained.
Finally, it is important throughout the process of restructuring a banking sy the general public does not have to fear for the loss of their life savings. A reliably insurance mechanism, a central bank that can provide liquidity to solvent, viable banks a functioning payments system are essential elements of the public sector safety net. The s true beneficiaries are not financial institutions, but the general public.
## IV. The Role of the Basle Committee
What do I see as the near and medium-term role of the Basle Committee and t organization of banking supervisors? What should be our goals to meet before the nex conference, to take place in New York in the Year 2000?
Let me begin by saying that the Core Principles lay out the major highwa effective banking supervision, but do not provide a detailed street plan. One important feedback we are receiving from the Core Principles Liaison Group, consisting of members Basle Committee and members of the emerging markets, along with more informal feedback, is need to provide more detailed street plans. There are several ways to achieve that.
The first is to continue to elaborate on the Core Principles by producing pa key topics to augment and update the Compendium. The Compendium is the set of relevant pa issued over the years by the Basle Committee which elaborate further on the Core Princi provide the next level of detail. In the past year, for example, we have published papers control systems for banks, interest rate risk management and operational risk that fill in gaps in the Compendium related to risk management and internal controls. These were prepa the Risk Management Subgroup, chaired by Roger Cole of the Federal Reserve Board and Chris Cumming of the Federal Reserve Bank of New York. We have work underway now in that Subgroup for future papers on supervisory issues in credit risk management, corporate governance an audit.
As another example, we issued a paper on the framework for enhancing transpare last month. The Transparency Subgroup intends to build upon that framework, with special em on trading, derivatives and credit risk disclosure. In addition, as noted, we published paper on loan valuation and loss reserves.
This probably is still not enough detail for many supervisors. The need fo detail may be better met through increased technical assistance provided by the Basle Comm Banking Supervision, along with similar assistance programs of its individual members. Mo the International Monetary Fund, the World Bank, and regional development banks have stepp their efforts to provide technical support as well. Often, the detailed street plan can only with very specific knowledge of the marketplaces, banks' powers and roles in the f system, and the laws and regulations of the country in question. Local supervisors and technical experts can work together to fashion specific supervisory guidance and regulatio appropriate in the local marketplace.
Additional resources are available from the Institute on Financial Stability effort of the G-10 central bank governors, the Basle Committee, the International Organi Securities Commissions (known as IOSCO) and the International Association of Insur Supervisors (known as IAIS). The purpose of the Institute is to provide training to senior and other supervisory staff in the application of basic supervisory principles to th supervisory systems. The job of senior supervisors in the emerging markets is an imm challenging one, requiring negotiation, management and leadership skills, in addition to supervisory skills. The Institute, by bringing together key policy-making officials in c and supervisory agencies through high-level seminars, serves the dual purpose of sharing and developing and deepening the relationships among supervisors globally. The Institute courses not only in Basle, but on a regional basis as well. The Institute will act as a for the coordination and provision of technical assistance by central banks and supervisory
We also must work closely with the IMF and the World Bank. These institutions people in virtually all of the world's countries to evaluate candidly the macroeconomic an climate and supervisory policies and practices. In an important development for the furth the Core Principles, the IMF and World Bank are using the Core Principles as the benchma evaluating supervisory regimes around the world.
This is an effort that the Basle Committee plans to support not only t continued work on the Core Principles and the Compendium, but by providing expertise supervisory resources to supplement and advise IMF and World Bank staff. The members of Basle Committee in many cases have the staff with the deep expertise to help emerging m supervisors with the application of the Principles in their national context and in lig
obstacles. The IMF and World Bank have expressed their desire to bring more of that expe bear in their efforts, and we have begun discussions on how to accomplish that most effec addition, we believe that first-hand observation of the practical issues in implementation what further elaboration and precision would be most useful to the Core Principles, a additional research and papers, programs by the Institute for Financial Stability or speci assistance could supplement them. Our goal is to keep the Core Principles relevant, inc implemented by supervisors globally.
In addition, we in the broader financial supervisory community must set thou goals for ourselves as we manage our individual agendas. The problems that have beset countries in Asia, Russia and other regions and countries are not confined to the banki although that may be the largest part of the financial sector. Together with IOSCO and the should work to strengthen internal financial firm management, supervision and market disci matter what the nature of the financial firm or market.
As a final point, let me stress that while we continue to elaborate the roadm Core Principles, we must also press on in understanding the frontiers of financial developm makes for a difficult and ambitious agenda, but we must be and we are up to the challenge.
The most important example of this broad effort is the work the Committee begun on the future of capital. We know the value the Basle Accord has had in strengthenin standards around the world. At the same time, we have recognized that advances in risk mana and financial practices are beginning to erode the relevance of the Accord for the most sophisticated banks. That means that we must identify ways to ensure that the Accord will meaningful guidance for the maintenance of strong capital levels at those banks, while stil the fundamental protection to the financial system that is needed in all countries.
To that end, the Committee has formed a Steering Group on the Future of Cap chaired by Claes Norgren of the Swedish Financial Supervisory Authority. It is my hope review conducted by the Steering Group will bring together new thinking on a minimum capita a comprehensive look at the supervisory evaluation of capital adequacy, which I described and enhancements to market discipline.
On this issue, as on all the others we have discussed this morning, we in th Committee must work and will be working closely with supervisors around the world. To tha we hope to work with the Core Principles Liaison Group, and the much broader Core Prin Consultation Group, which met earlier this week. One of our goals in 1999 is to enhance fu utility and the dialogue in those Groups, to ensure that we are jointly building the framework for the 21st century.