## Mr McDonough comments on Capital Markets, Securities and Government Sponsored Enterprises
Statement by the President of the Federal Reserve Bank of New York, Mr William McDonough, before the Committee on Banking and Financial Services, U.S. House Representatives, Washington, D.C., on 3 March 1999.
Good morning Chairmen Leach and Baker and members of the Subcommittee. When I appeared before the full Committee in October, I spoke about the near-collapse of Lo Capital Management and the events leading up to the private-sector recapitalizati fund, Long-Term Capital Portfolio. At that time, I promised you that we would take look at the issues growing out of that experience, particularly as they a responsibilities as bank supervisors. I am pleased to appear before you today to re lessons we have learned and the actions we have taken to reduce the possibility tha episode could repeat itself in the future.
As I indicated last fall, three issues require particular attention by banks and the in the wake of LTCM. These are, first, the adequacy of banks' credit analysis p second, the effectiveness of exposure measurement; and third, the role of stress counterparty exposure. In my remarks today I will detail the substantial progress th made, both domestically and internationally, to address each of these supervisory con
But before I get into the details, let me say that I believe the LTCM episode supervisory response to it is fundamentally about two things: leverage and good j Leverage is a fact of life in our financial world, and is a key part of the risk-ta for the creation of wealth. But sometimes banks go too far in extending credit customers and counterparties. That' s where good judgment comes in. I know - - I' there. I was a commercial banker for 22 years before becoming President of the New Fed, and I can tell you that the most important decisions a banker makes are how to to whom. Those decisions are not easy, and often involve many shades of gray. One aims as supervisors should be to see that banks are using the right tools to m judgments.
The importance of these issues extends beyond banks and their supervisors. Sound policies and procedures are essential not only for the stability of individual bank and more importantly - for the health of the financial system and the economy as This is because banks play a pivotal role in our economy as providers of credit. If poor credit decisions with respect to a borrower, including a hedge fund like LT financial system and our economy will suffer.
## Basle Report Findings
As you know, I chair the Basle Committee on Banking Supervision, comprised of b supervisors from the G-10 countries who coordinate supervisory policy for interna active banks. While the Committee does not have formal legal enforcement powers conclusions and recommendations are widely implemented, both in G-10 countries and m others. In late January, the Committee issued a report dealing with the relationsh
banks and highly-leveraged institutions, or 'HLIs'. The Committee' s report provides framework for addressing the broader issues raised by the LTCM episode, the polic responses of supervisors, and some key risk management challenges for the banking indust going forward.
In the United States, the Federal Reserve System, the New York State Banking Department and the Office of the Comptroller of the Currency have conducted target reviews of a num of large-bank dealings with hedge funds. These reviews contributed to the Committee' s wo to the Federal Reserve System' s issuance on February 1 of new guidance to financi examiners and banks, and to similar guidance from the Comptroller of the Currency issued January. These new standards emphasize the need for improvements in the credit ris management process at banks. The new standards will likely be complemented by a study of the implications of the LTCM episode by the President' s Working Group on Financial Markets.
Because the Basle Committee' s jurisdiction is limited to matters of banking supervision regulation, its primary emphasis has been on ensuring that the major banks prudently man their risk exposures to HLIs. The best way to achieve this is through the adoption of practices by the industry, perhaps supplemented by incentives created through capi requirements. While it is primarily the responsibility of each banking organization to m its risks, sound practice standards give banks and supervisors a tool to measure ind progress. If banks themselves do not follow sound practices, then supervisors must step i take the necessary action.
The Committee' s report revealed a number of deficiencies. In particular, the Committ observed an imbalance among the key elements of the credit risk management process, wit too strong a reliance upon collateral. This undue emphasis, in turn, caused many bank neglect other critical elements of effective credit risk management, including in-depth analyses of counterparties, effective exposure measurement and management techniques, an the use of stress testing.
## Credit Approval Process
For a bank to make sound lending decisions, it needs to obtain sufficient information the borrower. Supervisors routinely stress the need for banks to have an effective c approval process consisting of formal policies and procedures, accompanied by documentation of actual credit decisions. When dealing with an HLI, a bank also must obt comprehensive and timely financial information about that HLI' s risk profile and cr quality, and it must engage in an ongoing credit analysis of that HLI. In addition, a ban have a clear understanding of an HLI' s operations and risk management capabilities. T Committee observed weaknesses in each of these areas. Let me give a few examples.
The Committee found that banks did not obtain sufficient financial information to allow full assessment of how much and what types of risk had been assumed by large HLIs. I particular, banks did not obtain the information needed to measure leverage. They also di have sufficient information to understand HLIs' concentrations in particular markets and categories, or their exposure to broad trading strategies.
Similarly, banks generally did not sufficiently understand the ability of HLIs to m risks. Because risk profiles can change from one day to the next, or even from mo moment, it is necessary for a bank to be sure that the HLI can effectively manage it operations and risks on an ongoing basis. In general, we did not find sufficient HLIs' risk management systems and their underlying assumptions, back office systems u manage daily operations such as collateral and liquidity, and the major account valuation policies.
## Exposure Measurement
The Committee also thought that banks need to develop better measures for determini credit exposure resulting from different types of trading activities. In particular develop more effective measures of what is called 'potential future exposure.' Potent exposure measures the credit exposure between a counterparty and a bank, and how exposure could change in the future as market prices fluctuate. As we have seen, s movements can be substantial during periods of market stress. The ability of banks t potential future exposure is crucial when dealing with HLIs.
Unfortunately, methods for calculating potential future exposure had not kept pace growth and complexity of HLIs. Banks' potential future exposure measures have particularly ineffective in measuring exposures not covered by collateral. For examp highly volatile market conditions, a bank' s potential future exposure can grow be value of any collateral. We expect the industry to develop more effective ways to me limit potential future exposure, and supervisors will closely monitor progress to this occurs.
## Stress Testing
The Committee' s report also shows that banks must develop measures that better acco credit risk under highly volatile market conditions. This can be achieved through wh 'stress tests', where a bank conducts 'what if' analyses of how credit exposures t counterparty could grow under extreme market conditions. These might include a large fall in interest rates, a major change in an exchange rate, or a flight to quality the case of LTCM, stress testing could have given banks at least some warning of the exposures they could have faced last fall. The critical importance of stress test very explicitly in our new supervisory guidance.
## Sound Practice Guidance
The sound practices document accompanying the Basle report presents an important s standards that will guide both banks and their supervisors. It appears that banks gen tightened the credit risk management standards for their HLI exposures since the co LTCM. However, it is important that supervisors try to ensure that progress co Memories tend to be short, and we want to make sure that as markets calm down, as th in the past months, banks do not return to the old ways of doing business.
The adoption and rigorous enforcement of enhanced risk management practices sh contribute substantially to limiting excessive risk-taking and leverage at HLIs. Thi because HLIs cannot trade without access to financing and liquidity from banks and s
firms. If each counterparty manages its risks appropriately, the chance of contagion to institutions and the financial markets more broadly would be reduced substantially. It risk of contagion and financial market instability that is the principal concern of centr and supervisors.
Along with other federal banking supervisors, the Federal Reserve has moved quickly implement the recommendations of the Basle Committee' s report. As I mentioned earlier, w recently issued guidance to the institutions we supervise detailing sound risk managem practices for the credit risk management of trading and derivatives activities. This do identifies the areas that our examiners will review during their examination of tr activities. It is important to note that the Federal Reserve' s guidance to banks and ex covers not only HLI and hedge fund counterparties, but all other counterparty relations We want to ensure that banks carry forward the lessons of the LTCM experience to al potentially high-risk trading activities.
In this regard, our examiners will devote particular attention to the risks associat rapidly growing, highly profitable and potentially high-risk activities and product line will assess the adequacy of banks' reviews of counterparty creditworthiness, exposu measurement and monitoring techniques, stress testing, limit setting, and the appropriat of collateral and other credit enhancements. Our examiners will also look at internal po and the degree to which behavior conforms to stated policies. We have already conduct meetings with the major banks to reinforce these messages and our examiners will condu follow-up reviews in the course of this year.
## Other Possible Policy Responses
Over the past few months, there has been significant debate about other measures that c be taken to limit the potential risks to the financial system arising from the activitie highly leveraged, unregulated financial institutions. The Basle Committee carefu considered all the ideas that have surfaced. Our report discusses a variety of options the implementation of sound practice standards. One possibility is to require higher c charges for bank exposures to HLIs. Indeed, a primary objective of our current review of Basle Capital Accord is to determine how to align regulatory capital charges better wit economic risks of different classes of counterparties.
We also recognize the critical need to enhance market transparency for the activities of and other major market participants. The Committee already is working to enhance accounting and disclosure practices at banking institutions worldwide. Extending these ef to all global players that have the potential to destabilize the financial system, includ is of particular importance. An international group of central bankers is now studying v approaches to strengthening disclosure in this area.
The Committee also considered the advantages and disadvantages of imposing direct regulation on the HLI industry. There are a number of critical obstacles that would have overcome before a direct regulatory approach could be implemented. To be effective, a regulation would have to extend to jurisdictions around the world where HLIs are charte some of which have more highly developed and more stringent supervisory structures tha others. This would require a high level of coordination involving the political, legislat judicial bodies of many countries. There is also the difficulty of establishing a reg
regime for HLIs that is not easily circumvented. For these reasons, I believe the mo approach is to focus on financial institutions' lending activities, because such offers a near-term and cost-effective remedy to the systemic risks posed by HLIs.
## Challenges for the Banking Industry
I strongly believe that both the official and private sectors have important role addressing the challenges arising from an increasingly complex and dynamic fin services industry. First and foremost, we hold banks accountable for ensuring th credit risk management standards are upheld and that these keep pace with financia innovation. If competitive pressures lead to bad practices in one bank or the ind whole, our job as supervisors is to raise standards and ensure that sound practices a
In my remarks today, I highlighted a number of areas where progress has been mad course, there is more work to be done by banks and supervisors. High on the agenda sh the development of more meaningful measurement of risk exposure and the implementation of effective stress-testing techniques. Another important area th further industry attention is the measurement of leverage. Finally, I believe that should devote more thought to the appropriate valuation of positions during periods stress and illiquidity - which is particularly relevant to the use of collateral to credit risk.
These are just some of the broader issues arising from the LTCM experience and the turbulence last fall. But I believe that we are meeting the challenge and have made significant short-term progress.
I look forward to your questions.