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For Release On Delivery
9:43 a.m., cdt
10:45 a.m., EDT
May 2, 1996

"RETHINKING BANK REGULATION AND SUPERVISION"

by
Edward W. Kelley, Jr.
Member
Board of Governors of the Federal Reserve System
Before

Conference on Bank Structure and Competition

Federal Reserve Bank of Chicago
May 2, 1996

It is a pleasure to be here today. The theme for this year’s
conference, rethinking bank regulation, is quite timely. With the banking
industry’s strong capital condition, and profitability at record levels, it is a good
time to look ahead and consider the future without the distractions of a current
crisis. As with many things in life it is always useful to take a step back and
rethink what we are doing. It is especially useful at times like this when much
is changing in the financial services sector.
To guide our thoughts in rethinking bank regulation, we need to
ensure that we take a systematic, well targeted approach by focusing on the
Why, the What, and the How of regulation. In short, we must: (a) review why
we regulate banks and financial institutions in the first place; (b) take stock of
what we are supervising —that is how banks, and the environment in which
they operate are changing; (c) reassess whether our original reasons for
regulating banks still apply; and, (d) examine how we are supervising banks
today and how best to supervise them in the future.
It seems necessary to discuss each of these questions to develop a
coherent picture of where bank regulation and supervision is heading and the
direction it should take ~ in short, to answer the question "What should

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regulators do?". I will address each of these topics in turn, but will focus
mainly on the last issue: how to best supervise banks today and tomorrow.

Why we regulate banks.
Considering the first question: "Why do we regulate and supervise
banks?", there are two primary reasons:
1)

To ensure the safety and soundness of financial institutions so that
they do not become a source of systemic risk, pose a threat to the
payment system, or burden taxpayers with losses arising from the
federal safety net; and,

2)

To promote an efficient and effective banking system that finances
economic growth, impartially allocates credit, and meets the needs
of the customers and communities banks serve.

Balancing the goals of ensuring safety and soundness and
facilitating market efficiency and effectiveness has always posed challenges.
Today, supervisors face increasing pressures in this balancing act given the fast
pace of change in technology, financial products and management techniques --

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changes that are significantly affecting the way supervisory strategies are
achieved.

What we supervise - Changes underway in the industry.
The litany of technological and financial innovations that are
transforming the financial services industry is well known. Advances in
telecommunications and computer technology have provided banks new and
more efficient opportunities to expand regionally, nationally and globally. At
the same time, and driven largely by the same phenomena, financial innovations
have enabled banks to fine tune and expand product lines and activities,
allowing for a more targeted response to customer tastes and needs. Delivery
mechanisms are being dramatically transformed from banking through the
internet to redesigned branch offices offering a full array of banking, brokerage,
and insurance products. Without today’s computer technology banks could not
offer these products or keep pace with the increasing volumes of financial
transactions in both wholesale and retail markets.
The forces of technology and financial innovation are also changing
the structure of the industry and the way it is being managed. The recent wave
of mergers among larger organizations has been, in part, driven by the industry’s

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belief that technology can be exploited to achieve scale economies. Smaller
organizations also are successfully using technology to improve their efficiency
and ability to compete in their chosen markets. While technology and financial
innovation have increased the range and complexity of financial products, they
have also provided advances in the techniques used to identify, manage, and
control risks. These techniques range from sophisticated value-at-risk models
used at large trading organizations to credit risk scoring models used to evaluate
and track asset quality.

Reassessing whether our original reasons for regulating banks still apply
Do these changes in the industry undermine the traditional policy
objectives we initially laid out of promoting a sound, responsible, and
responsive banking system? Certainly not. Indeed, they intensify the need for
an active supervisory and regulatory process.
Advances in risk management certainly help in reducing potential
systemic disruptions. However, given the dramatic increase in the volume of
financial transactions over the past several years, the concentration of these
transactions among a relatively small number of institutions, and the increasing
complexity of many new financial instruments, some have argued that

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heightened linkages among national and international markets may have
increased the potential that an individual disturbance may be transmitted more
broadly, causing systemic difficulties. While innovations have provided new
opportunities to operate efficiently and to manage and control risk, they have
also created the potential for organizations to accumulate sizable losses over a
short period of time. The Barings incident is perhaps the most notable. Clearly,
the need remains for regulators to ensure that institutions are operating soundly
and that potential systemic disturbances are met with appropriate regulatory
responses.
Overall, the need for supervision and regulation to ensure that banks
operate safely and soundly is increasing, not diminishing.

But, in pursuing this

goal of ensuring safety and soundness it is also important that supervisors
continue to promote an effective and responsive banking system that efficiently
finances economic growth. To do so in an era of change, supervision and
regulation must change as well.

How supervision and regulation are changing.
While the original objectives remain appropriate, the manner in
which supervisors achieve them is changing both to accommodate industry

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evolution and to improve their own efficiencies by making better use of
available technology. Traditionally, supervisors have sought to achieve their
goals by imposing regulations, providing guidance, verifying bank activities, and
requiring or prodding the industry to make greater disclosures. Each element
remains important and is still evolving.
The nature of regulation is undergoing significant change.
Traditionally, regulations were strict prescriptions of rules with black and white
standards such as the maximum amount of loans to one borrower or lists of
permissible investments. While certain maximums, minimums, and laundry lists
remain necessary in many cases, they are becoming less effective. In the past,
supervisors and institutions often controlled risk by focusing on particular
products or activities where the risk was generally concentrated. For example,
market risk is generally associated with trading activities while credit risk is
concentrated in loan underwriting. However, recent advances that allow risks to
be separated from products and activities, and then reassembled in other forms,
have made product or activity-based rules less effective. Derivative instruments
can be effectively used to mitigate the market risks of traditional trading
instruments but, at the same time, can involve significant credit risks that may
not have been present before.

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Overall, more flexibility is required in regulatory approaches.
Regulations must be prescribed to address safety and soundness concerns but
cannot be so specific or narrow that they interfere with the process of
innovation. An example of such flexible rulemaking was the safety and
soundness standards the banking agencies adopted in response to Section 132 of
FDICIA. That section required regulators to prescribe standards in areas such as
loan documentation, internal controls, and compensation —just to name a few.
Such standards could have been specified using regulator imposed laundry lists
and requirements. However, the banking agencies adopted an approach that set
broad standards for what constituted safe and sound practice, leaving the
specifics of how that standard should be achieved to the bank. Not only does
that approach recognize the impracticality of imposing singular standards on the
diverse array of products offered by the more than 9,000 banks in this country,
it also allows banks to adjust their practices to fit the changing nature of their
products and activities.
Regulators should also be alert for ways to make their rules more
compatible with sound, internally developed practices in risk management in
order to reduce burden and to improve the effectiveness of their regulations.
One way we are trying to do this is in our proposed capital standards for market

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risk in a bank’s trading activities. These new standards will permit large trading
banks to use their internal "value-at-risk" models to calculate their future capital
requirements for market risk, subject to examiner oversight and a few regulatory
constraints.
Through their evaluations of many institutions, regulators are in a
unique position to identify and promote sound practices within the industry and
are offering their guidance more than they have in the past. In earlier years,
supervisors used guidance for relatively narrow purposes - typically to advise
examiners or bankers on interpretations of existing regulations or procedures for
compliance. Today, guidance is moving away from narrow, compliance
oriented details toward the identification and dissemination of sound practices
for the various activities banks conduct.
Please note my emphasis on "sound", not "best", practices. Sound
practices reflect those minimum principles to be employed to ensure that the
activity is conducted prudently. Best practice, in my view, can and does occur
in institutions of every size, shape and level of sophistication, but supervisors
should focus on sound practices and leave the determination of what is "best" to
the judgement of individual institutions.

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Since 1993, the U.S. banking agencies have issued a series of
instructions, policy statements, and examination manuals stressing the
importance of managing all risks posed by the institution’s activities. One
example of this guidance is the Federal Reserve’s supervisory letter and manual
on managing the risks related to trading activities, which were well received by
banks, auditing firms, and others.

I believe the dissemination of this type of

guidance is a good example of supervisors adding value and we expect to
continue to emphasize this approach in the future.
Although regulations and guidance are important, the cornerstone to
the bank supervisory process is the verification of prudent practices and
financial condition through on-site examinations, coupled with off-site
surveillance. Traditionally, on site examinations have focused on compliance
issues and verifying the condition of the institution at a point in time by
reconciling accounts, testing individual transactions and performing ratio
analysis. The examination process has also tended to involve very similar
procedures regardless of the bank’s unique mix of activities and risk profile.
This process is changing.
First, examiners are placing more emphasis on evaluating the
soundness of a bank’s process for managing and controlling risks. Although

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they must still reconcile and test certain transactions, single point-in-time
assessments of financial condition or compliance status are becoming less
effective indicators of an institution’s future risk exposures and compliance.
Testing the soundness of the institution’s risk management and internal control
processes provides greater assurance of an institution’s soundness on an ongoing
basis.
The Federal Reserve’s recent decision to assign a formal rating to
risk management in our examination reports reflects the importance we place on
sound management and adequate internal controls. For state member banks and
bank holding companies, this rating is given significant weight when
determining the rating for management under our bank and bank holding
company rating systems. While supervisors have long reviewed internal
controls during examinations, the process of developing formal ratings increases
the focus on risk management and highlights both the quantitative and
qualitative aspects of a bank’s system for identifying, measuring, monitoring,
and controlling its risks.
Second, to improve the examination process, the Federal Reserve
and other banking agencies are emphasizing more pre-visitation planning in

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order to better identify those areas of the bank’s activities that pose the greatest
risk. In other words, the examination scope now has a more customized focus.
Third, supervisors are making greater use of computer technology in
the examination process such as the use of automated systems that permit
examiners to download data from a bank’s computer, analyze portfolios on their
personal computers, and identify concentrations and other characteristics within
the bank’s loan portfolio. As a result, examiners should be able to reduce
materially the amount of time they spend on manual operations and should be
able to devote more time to identifying and evaluating risks.
This combination of focusing on the management process, planning
examinations better, and using automation more effectively should reduce the
amount of time examiners spend on-site performing clerical activities, and
increase the time they have to evaluate risk.
Supplementing the on-site examination process are surveillance
activities, which traditionally have involved standardized ratios and screens that
rely on regulatory reporting. However, those screens are sometimes not flexible
or comprehensive enough to provide a true profile of the bank’s risk -- so they
also need to improve. One enhancement is to tailor the information we collect to
the bank’s activities, including making greater use of internal management

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reports and the results of internal risk models. In recent years, supervisors have
expanded the focus from internal loan classification reports to the results of
banks’ sophisticated internal models and other risk management reports. Such
changes merely reflect the evolving nature of bank activities and the improved
procedures banks have for measuring those activities.
As with examinations, disclosure practices of the past also focused
narrowly on the financial condition of the institution at a point in time, using
conventional accounting and regulatory measures. Today, however, disclosures
are expanding to include a description not only of the level of risk taken by the
company but also of management’s philosophy for managing and controlling
risk. This improved transparency enhances market discipline and rewards
prudent management. We have already done much to improve disclosures for
derivatives and market risks, and we will continue to urge better and more
broadly based disclosure on all of an institution’s major activities and exposures.

Conclusion
In conclusion, I believe the traditional public policy goals of
regulation are still appropriate, but changes in the structure and activities of
financial institutions require that we rethink the way supervisors accomplish

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these tasks. Just as banks must adapt and change in response to the competitive
landscape around them, regulators must also periodically reassess and, when
necessary, restructure their activities to accommodate change. Our supervisory
procedures have and are changing to recognize new technologies and techniques
that are transforming the banking industry. Like the industry we need to rethink
how best to do our job on an ongoing basis. Thank you.

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