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8 00 A M C D T (9 00 A M
May 2 6 , 1 9 9 3
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D
T
)
Remarks by
Alan Greenspan
Chairman, Board of Governors of the Federal Reserve System
before the
Federal Reserve/SMU Banking Conference
Federal Reserve Bank of Dallas
Dallas, Texas
May 26, 1993
The Future of Banking
Law and Regulation
It is a pleasure to appear here today to discuss the future
of banking and, in particular, the future of banking law and
regulation
In truth, I was somewhat concerned over the prospect of
delivering a speech at the Dallas Fed on this subject after having
given a speech on the same topic at the Chicago Reserve Bank only
three weeks ago
I was worried that the two speeches would no doubt
be compared, and that either Bob McTeer or Si Keehn would feel
shortchanged
So I have come up with a Solomonesque solution -- I
will not cut the speech in half, but I will present essentially the
same remarks in both places
In all seriousness, in my judgment the remarks that I made in
Chicago bear repeating
The importance of a coherent and well
executed system of banking law and regulation for the health of our
banking system, and the broader economy, simply cannot be
overemphasized
What, then, should be the goals of banking
regulation, and how should we attempt to achieve those goals?
To understand optimal bank regulation, one should begin with
an understanding and appreciation of the role of banks in a modern
economy
Fundamentally, banks provide an intermediation function that
results in depositors receiving rates that are lower than the yields
on loans and securities, in return for increased safety, liquidity,
and payments services
The intermediation process, in turn, is
predicated on the ability of banks to develop specialized information
on the creditworthiness of their borrowers, and to use this
information in ways that take advantage of portfolio diversification
-2-
In other words, banks are in the business of managing risk
If done
correctly, the bank will create economic value by attracting savings
to finance investment
If done incorrectly, real resources will be
misallocated, and the bank may fail
Moreover, even if risk
measurement and management are done correctly the bank may still fail,
simply because it was unlucky
The historic franchise of commercial banking has always
depended upon the credit insights of the banker, his ability to gauge
the capacity and willingness of a borrower to repay a loan, his
ability to sense which risks appear to hedge others
These old
fashioned concepts are still relevant in evaluating today's commercial
banking, even as we move toward sophisticated risk-management
involving betas, covariances, and the impressive, evolving techniques
of risk reduction
Indeed, modern banking is not inherently different from
traditional banking, except that there are now many more financial
products involved than simple business and household loans
This
continually expanding list includes instruments such as futures,
swaps, caps, options, and other derivatives and guarantees -instruments that do double duty as products that unbundle risks for
customers, and act as tools for managing the bank's own risk position
As the complexity of the financial marketplace has increased,
so has the complexity of risk management
example
Many commercial banks, for
now employ formal C&I credit scoring models to assist in
assigning a risk rating to a prospective credit
Loan pricing models
now incorporate methods for disaggregating a loan s risk into its
separate components, and pricing these components against the
marketplace
There are also intrinsic-value pricing methods, such as
risk-adjusted return on capital models
But although modern banking
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may create sophisticated mathematical structures to measure and price
risk, the raw data of these systems remain the credit judgments of the
individual loan officers in classifying the risk of a potential loan
Risk can be priced properly, and the nonsystematic portion of
risk can be diversified away
But all risk cannot be eliminated
Even more important, the willingness to take risk is essential
to the growth of the macroeconomy
All businesses face risk, and
there is a systematic, positive relation between risk-taking and
potential reward
Much of the growth in employment in our economy is
associated with new firms (and often new technologies) coming into
existence at the very time that old firms (and old products or methods
of producing products) have gone out of existence
The new firms
exist only because they are willing to take on risk and, often, the
old ones go out of existence because they did not take risks, or at
least did not take the right risks
This replacement of stagnating
firms by firms with high potential for growth is what Schumpeter
referred to as the "perennial gale of creative destruction "
Indeed,
if all savers and their intermediaries attempted to invest only in
risk-free assets, then the potential for business growth, and the
growth of domestic product that flows from business success, would
never be realized
Modern, dynamic, competitive economies are characterized by
rapid obsolescence of products and services displaced by ever more
innovative ways of doing things
The extent to which new ventures are
created and old ones lapse is truly startling
Indeed, the gross
churning of employment is a clear reflection of that process
Currently, about 400,000 workers a week lose jobs as indicated by our
labor force surveys and unemployment insurance data
But since total
jobs are growing, albeit modestly, it means that gross additions to
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employment as a consequence of new firms, and expansion in existing
firms, are in excess of 400,000 per week
If risk-taking is a precondition of a growing economy, and if
banks themselves exist because they are willing to take on and manage
risk, what should be the objectives of bank regulation"?
Clearly,
optimal bank regulation should take care not to stifle the legitimate
risk-taking activities of well-intentioned and well-informed banks
However, the need for regulation exists because, as a society, we have
chosen to extend a system of government financed safety net guarantees
-- including deposit insurance and the discount window --to banks and
other insured depositories
This safety net, for all its benefits to
the stability of the financial system and the protection of individual
depositors, also provides banks with some incentive to take risks in
excess of those consistent with safe and sound banking
Thus, optimal
banking law and regulation must involve some benefit-cost trade-offs
between, on the one hand, protecting the financial system and
taxpayers, and on the other hand, allowing banks to perform their
essential risk-taking functions
Establishing the appropriate levels
of such trade-offs is inherently difficult, complex, and requires
considerable judgment, but is absolutely essential to implementing
sound regulatory policy
Herein lies the basic problem with much of U S
and regulation
banking law
The legislative and regulatory process, in my
judgment, has never adequately wrestled with the question of just how
much risk is optimal
Recent banking law has too often constituted a
series of reactions to perceived excesses, and thereby tipped the
optimum regulatory balance
For example, the real estate appraisal
requirements of FIRREA -- the Financial Institutions Reform, Recovery,
and Enforcement Act of 1989 - - were designed mainly to eliminate
-5-
excesses in commercial real estate and development lending, but these
provisions have ended up also excessively constraining banks' lending
to small businesses
More generally, the toughened examination
standards of the late 1980s and early 1990s were reactions to the
lending excesses of the 1980s, but have also contributed to the credit
crunch of the 1990s
The Federal Deposit Insurance Corporation Improvement Act of
1991 ("FDICIA") also was a reaction, this time by the Congress, partly
to excesses by the industry and partly to perceived inadequacies of
the regulators
While these concerns surely needed to be addressed,
the essential problem with FDICIA, in my view, was that its authors
did not consider appropriately the question of optimal risk-taking by
banks
Rather, the Act aimed at recapitalizing the Bank Insurance
Fund, and making sure that future costs to the deposit insurance fund
were minimized
But there is danger here
If minimizing risks to
taxpayers is interpreted as minimizing bank failure, then we are very
likely to deter banks to an excessive degree from accepting the kinds
of risk that create the value of their franchises
of bank failure is not zero, and, in all likelihood
The optimal degree
not even close to
zero
Perhaps the Congress and we regulators should step back and
ponder the answers to some basic questions
What is the optimal degree of risk-taking by regulated
financial
institutions?
In order to have a vibrant, expanding
economy, to what degree of risk should depositors or taxpayers be
exposed?
Second, with what kinds of risks, especially new risks,
should we concern
examples here
ourselves?
Derivative markets provide important
As banks invent and use ever more complex instruments,
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it becomes even more important for regulation to define clearly just
where the regulatory risks lie
By doing this, regulators can take
actions that address our legitimate concerns, but that do not stifle
innovation
Third, which entities should be subject to regulatory
controls over their risk-taking activities?
Fourth, what tools should regulators use to measure and limit
risk-taking?
Here I would emphasize that "tools" should be broadly
defined to include the use of not only modern analytical and empirical
methods, but also a highly educated and sophisticated staff throughout
the supervisory function
Indeed, the maintenance of a high quality
staff is probably the single most important prerequisite for
successfully implementing the principles of optimal regulation
As an
example, I would note that we are considering the formation of
highly trained and specialized teams of examiners to assess the assetliability models and other procedures used by bankers to manage
interest rate risk
Fifth, to what extent should we seek global convergence of
supervision and regulation?
Certainly, individual country banking
structures and cultures differ, and they are not all subject to the
same forces
In one area closely related to banking, the payments
system, international convergence could significantly reduce risk
without impairing innovation
As indicated in the Promisel Report,
issued in October 1992 under the auspices of the Basle Committee,
improvements in netting schemes, accounting and disclosure rules, and
the removal of cross-border legal uncertainties, would significantly
lower payments risk
This is of special importance as payments
systems become ever larger in the years ahead
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I do not propose to answer the questions I have posed here
today, only to emphasize that regulators and the Congress should give
them more thought
My predilection is that while risk-taking should
be restrained, we should not seek to minimize it
Regardless of the
degree of permitted risk-taking, I also believe that the specific
tools used by regulators to measure and control bank risk-taking
generally should not be legislated
There is a danger that legislated
tools will be formulistic, and will result in an overemphasis on
regulation, which is the writing of rules that apply to all
institutions, rather than supervision, which strives to take into
account the differences across institutions
A characteristic of the modern banking system is that
technological advances breed increasing numbers of ways to take on
risk, as well as increasing numbers of ways to measure and control
risk
Thus, we see ever more diversity across banks in their
approaches toward risk management
No single quantitative standard or
ratio could capture this diversity across institutions, nor even
capture the complexity of risk at any one institution
Moreover,
rigidly applied formulas can not adequately take account of the need
for banks to evolve, regulatory formulas may, in fact, discourage
productive innovation
Given these thoughts regarding optimal bank regulation, how
should we assess the most recent example of banking legislation,
FDICIA, and its ongoing implementation?
The portion of the Act that,
in my judgment, is most inconsistent with appropriate bank regulation
is Section 132 -- what I and others have termed the micromanagement
provisions of FDICIA
Section 132 directs each Federal banking agency
to set standards regarding operations, management, asset quality,
earnings, stock values (if feasible), and employee compensation
The
necessary regulatory response to this portion of the legislation, and
the anticipated industry response to the new regulations, have and
will divert scarce human resources at regulatory agencies, add to the
regulatory burden on the industry, and create uncertainties, all of
which reduce the incentives of bankers to take on risk, perhaps even
reasonable business risk
The creation of uncertainties has been especially burdensome,
because FDICIA was passed in December of 1991, but the provisions of
Section 132 will not be finalized until this summer, and they will not
take effect until later in 1993
During this almost two year period,
while regulatory agencies have been wrestling with meeting the letter
and intent of the legislation, bankers no doubt have been reluctant to
take new initiatives that may run afoul of rules yet to be announced
The agencies, meanwhile, have been trying to meet the intent of the
Congress while minimizing the burden on banks and the deleterious
effects on the supply of credit
Late last month, the Federal Reserve approved for publication
a Notice of Proposed Rulemaking regarding Section 132 Safety and
Soundness Standards
I anticipate that bankers will offer timely and
constructive criticism so that final adoption can proceed apace
It
is the Board's hope that, as the regulations are being implemented,
the agencies and the industry will be diligent in seeking to ensure
that the intent of the law is achieved at minimum cost
Finally, in
response to continuing serious concerns regarding excessive regulatory
burdens in banking, the Federal Financial Institutions Examination
Council is expected to propose legislative changes later this spring
I trust the Congress will consider these proposals carefully
FDICIA requires that risk-based capital include standards for
interest rate risk, the risk of concentrations of credit, and the risk
-9-
of nontradltional activities
The legislative language calls for
improving risk-based capital in such a way as to make the capital
ratios better indicators of bank safety and soundness
The regulatory
agencies are attempting to achieve this congressional intent without
subjecting banks to rigid formulas and heavy reporting requirements
that are unlikely to prove fruitful in achieving improved capital
measurements
Indeed, a reading of the draft Notice of Proposed
Rulemaking concerning interest rate risk, approved for publication by
the Federal Reserve Board in March, should convince observers that
great care is being taken in the implementation of this provision
For example, many institutions with demonstrably low interest rate
risk would be exempt from the reporting requirements of the proposed
rule, and many others could use their internal asset - liability
management models to demonstrate that they are taking on acceptable
levels of rate risk
The ability to use their own rate risk models
should encourage market participants to continue to develop and refine
interest rate risk measurement and management systems, as knowledge
and technology in this area evolve
Similarly, the draft proposals on concentrations of credit
and the risk of nontraditional activities recognize that such risks
depend critically on the details of the asset composition of the
individual bank, and on management expertise and information systems
Again, no numerical standard, however complex, is likely to capture
these important details as they affect overall banking risk
In
addition, the state of scientific knowledge in these areas is, quite
frankly, rather crude
Quantitative standards here could give a false
sense of precision and, very possibly, could inhibit the development
of more sophisticated and effective approaches to risk management
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For these reasons, the proposed regulations minimize the use of
formulas and rely heavily on the supervisory process
Let me emphasize that the prudent supervision of banking
organizations must be forward looking, and consistent with the goals
and objectives of optimal regulation
Any other approach will be
at best counterproductive, and at worst may deter the innovation
and risk-taking that are essential for a growing economy
Forward-
looking policymakers should also be concerned about the potential for
future decline in the value of the banking franchise
This is
important not because it is our job to worry about bank shareholders,
but because laws and regulations that reduce the ability of banks to
bring value-added to the risk management process also happen to reduce
the value of the banking franchise
I would like to conclude my
remarks by commenting on these issues
While the short- to intermediate-term prospects for the
industry should not give us cause for concern, I am less sanguine
about the long run
Bank commercial and industrial lending as a
percentage of total borrowing by nonfinancial businesses has been
declining for many years
This trend is disturbing for reasons that
go beyond contemporary concerns about the causes of the recent credit
crunch
American businesses increasingly are borrowing directly from
investors in the form of commercial paper and other debt obligations,
or they are borrowing from nonbank financial institutions
this light, the issue becomes one of the future role of U S
Viewed in
banks in
the overall provision of financial services, not just loans
This challenge to banks has occurred largely as a result of
the technological changes that have permitted investors to make their
own evaluations regarding credit and market risk, thereby allowing
investors to lend directly to larger borrowers
To some extent.
-11-
banking organizations have responded to these changes by participating
themselves in the increase in direct investor-borrower deals
The Board has acted, within the confines of existing law, to allow
banks to evolve along with technological change
Nevertheless, the
restrictions of Glass-Steagall, in the absence of significant reform
legislation, imply that the challenge to banks' role in financial
intermediation will continue to be driven to a substantial degree by
artificial legislative constraints, not market conditions
Besides
Glass-Steagall, other legal impediments to needed structural reform in
banking - - such as restrictions on interstate branching - - remain
firmly in place.
Public policy, in my view, should be concerned with the
decline in the importance of banking
To the extent that market
forces are displacing the intermediation functions of banks, economic
efficiency is not being impaired, but to the extent that unnecessary
laws and regulations are responsible for the decline, there is a
significant reduction in allocative efficiency associated with
preventing banking companies from fully exercising their abilities to
underwrite and manage risk
As the nonbankmg sector expands relative
to the banking sector -- because of artificial legal barriers to bank
expansion -- human resources, physical assets, and capital must be
reallocated to the nonbank sector
reallocation are not trivial
The "transaction costs" of this
Further, the banking sector loses the
opportunity to fully diversify its activities in a way that may permit
it to move toward the risk-return frontier rather than remain inside
it
Finally, and most importantly, the consumers of financial
services are denied the lower prices, increased access, and higher
quality services that would accompany the increased competition
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associated with permitting banking companies to expand their
activities
The debate over the repeal of Glass-Steagall provides an
interesting and instructive case study of the difficulty in achieving
legislative reform
The possibility of repeal of Glass-Steagall has
been raised many times over the last two decades, but, each time, the
opponents of repeal have mustered arguments to defeat such proposals
Recently for example, in 1991, when the recommendations of the
Treasury Department regarding expanded powers were being considered
(and ultimately rejected in the final FDICIA legislation), a popular
argument against reform was that banks were in trouble with low
earnings and high loan loss provisions
Expanded powers at that time,
it was argued, would only lead to additional risk that could cause
more bank failures
Now, in 1993, opponents of reform argue that bank
profits are at historically record levels, therefore, expanded powers
are not needed by the banks to maintain their profitability
Apparently, there is no good time for reform
argument is disturbing
the future of the U.S
This line of
We cannot afford to be complacent regarding
banking industry
The issues are too important
for the future growth of our economy and the welfare of our citizens
I trust that the Congress will see FDICIA not as an end in itself, but
as providing a vehicle for allowing needed restructuring of our
banking industry
Equally important, I would hope that our
experiences with the portions of FDICIA that impose excessive burdens
on banks have taught us that existing and proposed banking laws must
be evaluated to determine their likely impacts on the soundness and
competitiveness of our banking system
And, once legislation is
passed, it must be implemented in a way that preserves the value-added
of the banking system, by not confining banks in a regulatory
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straitjacket that stifles innovation and prudent risk management
Further, this must be done in a way that properly balances the banks'
role as risk-takers and risk managers with the public policy concerns
of bank safety and protection of the taxpayer
By adhering to the
principles of optimal banking law and regulation, we can greatly
assist in the process of achieving a healthy and dynamic economy
* * * * *
@FedFRASER