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Remarks by Governor Laurence H. Meyer
At the Conference of State Bank Supervisors, Williamsburg, Virginia
June 3, 1999

Moving Forward into the 21st Century
It is a pleasure to be here, when--once again--the industry has enjoyed another year of strong
performance. That is not to say bank supervision and regulation today is without its
challenges, or that there are few risks to U.S. banks. Perhaps to the contrary, as a result of
market dynamics, both domestically and abroad, we can expect to see some loan losses and
earnings pressures. Some weaknesses have already surfaced. For the most part, though, we
continue to be spared the crisis events that can be so disruptive.
This "lull" in domestic financial problems has come at an opportune time, as U.S. and world
financial systems adjust to the profound changes of the last decade. The number of insured
commercial banks continues to decline--down 4 percent last year and by roughly one-third
since the decade began. Meanwhile, the scope and pace of financial innovation continues to
expand, making many transactions increasingly difficult to manage and more opaque. Risk
management and measurement techniques throughout the industry have become much more
quantified with greater integration of information systems and financial theory. Large banks,
in particular, have also become far more diversified, now that they can expand nationwide.
These changes and the industry's transition, in general, should be viewed as a continuous
and natural response by banks to evolving market needs and new technologies. That the
industry, itself, is changing is not a problem; banks must adapt to survive. The fact that the
industry, rather than the legislative or regulatory process, is leading the change is also
appropriate; the private sector should almost always show the way. The result, though, must
be managed with care. During the 1990s, banking organizations have increased
tremendously in size as a result of the consolidation process, and the complexity of many
bank activities has grown as well. These developments have crucial implications for bank
supervisors, including those pertaining to systemic risks. In many respects, they have also
made bank supervision more difficult.
We have not yet achieved "financial modernization" in terms of legislation, but we certainly
have a far different banking and financial industry than existed a decade ago. Undoubtedly,
more change is on the horizon, as distinctions among financial institutions continue to erode.
That fact simply underscores the need for Congress to modify U.S. banking laws and permit
the regulatory environment to catch up with market events.
Meanwhile, bank supervisors and regulators should remain focused on their principal tasks.
First, to ensure that the banking system remains sufficiently safe and sound, posing little risk
to the federal safety net and adequately protected against systemic risk. Second, to ensure
that the industry continues to provide the American public with a full range of competitively

priced banking services and conforms to legislative standards of competitiveness. Perhaps
more than before, achieving these goals requires us to adapt our practices to changing
circumstances within the banking industry and to take full advantage of the technologies that
Clearly, as the industry has changed, so has bank supervision. As banks expanded
nationwide, state and federal supervisors worked together, producing the interstate
supervisory protocol that provides a more seamless oversight process for state chartered
banks. As banks grew larger and more complex, we focused more on risk management
practices and controls and less on a bank's condition at a point in time. We also became
more risk focused in our overall supervisory approach, emphasizing those activities that
presented the greatest risks. As financial innovation and capital arbitrage took hold, we also
became more aware of the need to update regulatory capital standards and to make greater
use of market discipline.
We are pursuing our objectives both domestically among ourselves and abroad through the
Basel Committee on Bank Supervision, under the auspices of the Bank for International
Settlements in Basel, Switzerland. We are designing a way forward, building upon the
"three pillars" approach outlined in a consultative document released today by the Basel
Supervisors Committee, a subject I will return to in a moment. This approach encompasses
(1) a strong, risk-sensitive regulatory capital standard; (2) an active supervisory program;
and (3) improved bank disclosures that allow the marketplace to evaluate an institution's risk
posture and to reward or discipline it appropriately.
In my remarks today, I would like to address many of these and other points, with particular
emphasis on the supervisory process and how we at the Federal Reserve are adapting to
change. At the outset, I would emphasize that bank supervision is, by its nature, a dynamic
process. Our practices must constantly improve or they will become quickly outdated.
Supervisors must also be flexible, both in their application of supervisory techniques to
banks and in their expectations regarding what practices individual banks should follow.
Perhaps more so than any other, the U.S. banking system is highly diverse, with its
thousands of small community banks and a small number of increasingly large, highly
complex, internationally active institutions accounting for a growing share of total bank
assets. Neither a single supervisory approach, nor a single risk management technique will
work for all. That need for flexibility and adaptation has been well served by our dual
banking system and by the ability of individual states and state chartered banks to innovate.
Large and Complex Banking Organizations
One aspect of supervision that has become more crucial to our oversight process relates to
systemic risk and to the activities of our largest banking organizations. A decade ago, for
example, the 20 largest U.S. banking organizations held 68 percent of the assets of the 50
largest bank holding companies; now its 82 percent. Then, the 20 largest holding companies
held 37 percent of all U.S. commercial bank assets; now that figure has risen to 64 percent.
Those figures conceal, of course, the dramatic increase in the complexity of their activities
represented by securitizations and derivative products. The notional value of derivative and
futures contracts held by U.S. banks now exceeds $33 trillion, nearly five times the level at
the end of 1990. Securitizations by U.S. banks, at $270 billion, have grown as fast and are
expanding beyond consumer-based loans, such as credit card and auto loans, to commercial

credits. Virtually all of these securitization and derivative activities are concentrated among
the largest banks. While notional values and amounts securitized say almost nothing about
the level of underlying risk to individual banks, they speak strongly to the increased volume
and complexity of large bank activities and of the somewhat hidden risks they face. For
these organizations, balance sheets and traditional lending have much different meanings
from a decade ago.
Last year, the Federal Reserve responded to this trend by sharpening its supervisory focus
on a smaller number of large complex banking organizations, both domestic and foreign.
We now give increased attention to roughly twenty U.S.-owned and another ten foreignowned banks. Although they are generally the largest institutions we supervise, they warrant
the greater attention not only because of their size, but also because of their on-and offbalance sheet activities, their broad range of products and services, their more complex
domestic and international oversight structure, and their role in payment and settlement
systems. We refer to them as LCBOs, for "large, complex banking organizations."
In supervising these institutions we recognize that each is unique and complex and that it is
particularly necessary for our analysts, examiners, and supervisors to understand sound
practices within the industry and to compare activities and risk management techniques
among institutions. Accordingly, we are taking a "portfolio" approach, whereby we evaluate
practices across institutions where we find similar business lines, characteristics, and risk
profiles. This approach fosters more informed and consistent supervision among institutions
and provides supervisory staff with greater opportunities to identify and promote sound
practices. It also accommodates more readily the development and coordination of staff
expertise throughout the Federal Reserve System.
The Federal Reserve's supervisory approach toward LCBOs requires ongoing monitoring,
including a formal re-evaluation of an institution's risk profile and a quarterly update of our
supervisory plan. This periodic assessment is based, in part, on internal management reports,
internal and external audit reports, and publicly available information. Since these
organizations typically conduct a broad range of regulated activities, supervisory staff must
also frequently communicate and coordinate their own activities with those of other bank
and nonbank regulators.
Management of this oversight process rests with a senior staff member designated as CPC,
or "central point of contact." That individual, in turn, coordinates virtually all interaction
between the Federal Reserve and the institution, and directs an identified team of
examination and supervisory staff having specialized skills tailored to the unique profile of
the institution. This structure, combined with the ability of the CPC to draw upon additional
staff throughout the Federal Reserve System, should promote greater understanding of an
institution's business and risk management process, while reducing our level of intrusion.
Indeed, a necessary aspect of our supervisory review is maintaining a steady flow of
relevant information about an institution's exposures and risk management system in order
to reduce the time-consuming and burdensome discovery process often associated with
traditional examination and oversight techniques. Periodic review of management reports
should not only enhance our knowledge of specific exposures and events, but also provide
insights into a bank's control process and about what information management deems
important. In some cases, it may be most convenient to us and to the bank if we have direct
access, on-line, to management information. Indeed, that is the case now for a couple of our

largest institutions, particularly with respect to the internal audit process.
Effective supervision of an LCBO requires a supervisory plan that is tailored to the
institution's current risk profile and organizational and operational structure and that
considers the activities of other supervisors--highlighting, once again, the need for
communication and coordination. The plan should address the major risks (e.g., credit risk,
market risk, and so forth) and should employ follow-up actions ranging from off-site
analysis and meetings with management, to targeted or full-scope examinations. CPCs
should also structure the plan to achieve the proper balance of review of risk management
practices and transaction testing, the latter relying typically on statistically sound sampling
Information sharing and coordination with other supervisors are key elements of the
program and are essential to successful supervision of these large institutions. For this
purpose, the Federal Reserve will continue to enhance its base of information technology
and extend its resources to other supervisors. Many of you are already aware of an
information system we are developing called the Banking Organization National Desktop,
or "BOND." When introduced next year, that system should provide supervisors with both
public and confidential information about an institution in a highly user-friendly way. The
system should prove particularly helpful in monitoring and evaluating conditions at the
largest institutions.
For the system to be useful, though, it needs to be used--and to be fed the information
people want. These requirements, in turn, require a high degree of security, so that
individuals can take comfort that information they put into the system is not misused or
misdirected. This aspect of the system has been given great importance and should actually
strengthen the level of security surrounding confidential information, while also
disseminating necessary information.
In supervising LCBOs, we not only expect more of ourselves, we also have higher standards
for the institutions. A fundamental tenet of supervision is that the nature of a bank's risk
management process must be consistent with the level of underlying risk. More
sophistication is necessary as transaction volume and complexity rise.
Credit Risk and Capital
Our higher expectations in the level of management skills and sophistication at larger banks
will also become more apparent in the years ahead in terms of capital standards. Much has
been said recently in supervisory statements and industry publications about the need to
revise the 1988 Basel Capital Accord and to improve, more generally, the credit risk
management of banks. Credit risk has always been the dominant risk in banking, yet it
remains crudely measured. This lack of quantitatively rigorous risk measurement within the
industry explains why we developed the current Accord as we did.
The trouble is that measuring credit risk is hard. Experienced bankers and examiners can
usually distinguish a good loan from a bad one, but quantifying the level of risk on a
portfolio basis and bank-wide is quite a different matter. Much attention has been devoted to
the exercise within the industry and among bank supervisors, but no solution is at hand. Best
practice banks and early research at the Federal Reserve suggest that significant strides are
being made in credit risk management, but the industry and regulators still have a long way
to go. It is--and should be--the highest priority for the industry and the supervisors.

Last year, as you may recall, the United States and the other countries represented on the
Basel Supervisors Committee adopted new capital requirements for trading activities that
are based on a bank's internal measure of "value at risk." That regulatory amendment
represented an important shift in regulatory thinking and a greater willingness by the
regulatory community to build on risk management practices of banks. With market risk,
though, the basic elements of the "value-at-risk" measure were relatively well established,
although most institutions still needed to strengthen certain aspects of their calculations and
management processes.
In that exercise, the necessary data for identifying current trading positions and measuring
the historical volatility of their market values were also generally available. The mark-tomarket process and short horizon of daily trading also helped greatly in evaluating the
effectiveness and overall "accuracy" of the market risk models.
None of these crucial elements exists today for measuring credit risk, and industry practice
has not yet converged around a particular measure of credit risk, or even a conceptual
definition of credit loss. Some models, for example, identify a loss only when a borrower
defaults, largely reflecting the view that the bank will hold the asset until it matures. If the
model forecasts a default during the relevant time horizon, it then calculates an expected
loss, or "loss rate, given default." Other models take more of a mark-to-market approach,
recognizing the gains or losses in the economic value of a loan portfolio resulting not only
from defaults or expected defaults, but also from changes in the credit quality of a borrower
or from different market and economic conditions.
As you can sense, model structures and assumptions become crucial. Moreover, the
fundamental input--a borrower's credit risk rating--can be highly subjective and is largely
determined internally within the bank. Some borrowers have public debt ratings from
recognized rating agencies, but most do not. Even a public rating needs to be translated into
the rating schedule of each bank. This lack of credit risk data is a serious weakness, with
even large banks lacking enough historical default experience for a given borrower type to
determine appropriate capital charges without substantial judgmental input.
The subjective and variable quality of risk ratings, lack of historical data, and the long time
horizon before answers are known about a portfolio's underlying strength make validating
credit risk models a difficult task. If more risk-sensitive models are to be used for regulatory
capital standards, these differences become more important because they can have material
effects on competition and on the safety and soundness of banks, both domestically and
Moreover, unlike trading activities, where the related capital requirements represent a small
part of the total, credit risk counts. We need to get this measure right for obvious reasons.
"Getting it right" means also providing the proper risk management incentives to banks.
Far more needs to be done in measuring and managing credit risk than has been done so far
by U.S. and foreign banks. As I noted, much progress has been made in recent years, make
no mistake. But much more progress is necessary before most large banks, themselves, can
gain a solid grasp on their risk exposures for risk management purposes, let alone before
supervisors will be able to substantially revise the Capital Accord.
In recent months Federal Reserve staff visited a number of large money center banks to

understand better what role credit risk models perform now in senior management's internal
assessments of the institution's capital adequacy. While, again, progress is being made, the
results were somewhat disappointing. Nearly all institutions indicated that in their own
internal reviews, they focused largely on factors such as their targeted external credit rating
and their regulatory risk-based capital ratios relative to those of their primary competitors. If
these figures were in line, they generally viewed their capital as adequate. Although the
targeted and actual ratios were significantly above regulatory minimums, these responses
were disappointing, indeed.
It should be noted that a key ingredient in rating agency evaluations of bank capital is the
risk-based capital ratio. While we regulators are flattered by the use of our capital standard
for internal and marketplace analysis, we must emphasize that the well-known shortcomings
of the standard make it an inappropriate tool for many internal and market purposes. We
expect institutions to be ahead of regulators in this analysis, not the other way around.
Where models are available, generally pertaining to commercial credits, they are used
principally in setting concentration and exposure limits, pricing, and evaluating performance
on a risk/return basis. Important uses, for sure, but in no case did management indicate their
risk measures offered a significant input to evaluating the institution's overall capital
This assessment is not intended to be pessimistic. I believe significant progress can be made
if sufficient attention and resources are devoted to the effort, and if the industry is given the
right incentives to make it work. Supervisors can provide some of the incentives--both the
carrot of an improved capital standard and a better risk management process, and the stick
that management will be judged, in part, by its ability to quantify risk. In large part, virtue
can also be its own reward. Banks that effectively measure and manage risk will make and
price credit better.
New Capital Proposal
As I mentioned earlier, the Basel Committee on Banking Supervision has now released its
long awaited consultative report on revisions to the 1988 Basel Capital Accord. For the
largest institutions, the Accord has increasingly been weakened by the changes that have
occurred in financial markets. Most importantly banks here and abroad have been engaging
in capital arbitrage techniques designed to move their higher quality, lower-risk assets to
securities markets, sometimes reducing their capital charges on these assets more than
proportional to the retained risk positions. In addition, the remaining higher-credit risk
assets have the same regulatory capital charges as the lower-risk assets that have been
securitized, changing the meaning of the resultant capital ratio. For these and other reasons,
the 1988 Accord has become increasingly undermined and the risk-weighted capital ratios
have become more difficult to interpret.
Modifying the Accord is an incredibly complex and difficult procedure, not only because it
must be negotiated among 12 nations and affect the policies of many more, but also because
the issues are so difficult. As I noted, the underlying approach has three equally important
legs, all of which reflect efforts to respond to the evolving changes in financial markets. The
first leg is modification of the capital Accord per se, especially for the large complex
banking organizations, the most important of which will be to change the risk-weighting
scheme on portfolio assets. The framework calls for moving from a four-weight scheme-with most of the assets at one weight regardless of risk--to multiple and more sensitive risk

weights and also includes steps to curtail loopholes dealing with securitization transactions.
The risk weights, in turn, would be based perhaps on one or a combination of techniques:
external ratings, internal management risk ratings, and/or bank-specific formal risk models.
Please note that in each of these, the process is leveraging off the market's risk evaluation,
including what the bank management applies for its own purposes. Consistency and
improvement in bank risk management is thus a prerequisite to improved, and more rational,
capital regulation.
The second leg is increased market discipline. Market discipline, of course, can occur only
to the extent that the banks make information available to creditors and counterparties that
have the ability to respond to that information. Thus, the consultative document
contemplates more transparency about bank risk-taking and controls so that creditors and
counterparties can decide more rationally about their required compensation for the risk of
dealing with that bank. Of course, the objective is to create the incentives for more rational
and efficient risk taking by the bank.
The final leg is supervisory review of the capital adequacy of the banking organization. The
purpose is twofold: first, to ensure that a bank's capital position is consistent with its overall
risk profile and strategy and, second, to encourage early supervisory intervention. The
purpose of this review is to provide supervisory comfort that each bank's internal process for
assessing its capital adequacy, and that each bank's actual capital levels, are consistent with
the scale and complexity of its risk taking activities. In some cases, these reviews may well
result in requiring individual banks to hold more capital than the minimum regulatory
As we think about capital standards for the years ahead, it seems appropriate to consider a
more bifurcated approach: one standard for large, complex institutions; another for most
other banks. That direction seems especially necessary if we do pursue a more sophisticated,
risk sensitive measure of credit risk to capture developments and techniques at the larger
and more complex banking organizations. My sense is that greater complexity would be
unnecessary for community banks, where a simpler, less burdensome approach may be quite
satisfactory for supervisory purposes for most banks. Nevertheless, all banks should take to
heart the message the Federal Reserve and other supervisors are sending about the need for
stronger practices for evaluating credit risk.
Loan Loss Reserves
On the topic of capital, I would like to say a few words about loan loss reserves and the
interaction of the Federal Reserve and other federal banking agencies with the Securities and
Exchange Commission. In recent months, as you know, the Commission has devoted
increased attention to practices of large U.S. banks in setting their level of loan loss
reserves. The issue surfaced last fall, when SunTrust was required to reduce its reserves and
revise previous financial statements. Since then, several other institutions have been asked
to explain their reserve practices to staff of the SEC.
As supervisor of these holding companies, the Federal Reserve has been actively involved in
this matter from the outset and has urged the Commission to work with us, with the
institutions, and with the other banking agencies toward a satisfactory resolution. Obviously,
this means reconciling different perspectives on this issue. For example, in light of increased
volatility and banking risks in recent years, the banking industry has appropriately
maintained robust reserving practices and levels.

From a safety and soundness perspective, the Federal Reserve and other banking regulators
have expected institutions to maintain strong loan loss reserves that are conservatively
measured. In carrying out its responsibilities, the SEC has emphasized the need for financial
statements and reported earnings to be transparent and, therefore, for allowances to be
adequate but not excessive. Enhanced transparency has also been a critical objective of bank
regulators, both domestically and internationally.
Last week, press reports characterized the Fed's position as being different from that of other
federal banking agencies. That is not true. The main point of contention between the
banking agencies and the SEC appears to be whether the recent guidance issued by the
Financial Accounting Standards Board (FASB) represents a mandate to reduce reserves. The
Federal Reserve has worked with the SEC to issue guidance emphasizing that the FASB
guidance does not mandate any material change and that bank management should feel free
to maintain reserves at the high end of a reasonable range.
The Federal Reserve's policy guidance provides background information that is intended to
assist institutions and their auditors in understanding the SEC announcement and the FASB
article in the broader context of other accounting initiatives and discussions between the
SEC and the Federal Reserve on allowance accounting matters. Moreover, our policy letter
sends a clear message that the Federal Reserve wants banks to maintain prudent reserving
practices and not to over-react as a result of a narrow interpretation of the FASB guidance.
The other banking agencies appear less sanguine about the intent of the FASB guidance and
have registered protests on Capitol Hill.
The Federal Reserve will continue to work with the SEC and the accounting profession in
the months to come in providing further information regarding appropriate documentation
and other matters. I understand Richard Spillenkothen, the Federal Reserve's Director of
Banking Supervision and Regulation, will also speak to this topic in his comments at lunch.
Disclosure and Market Discipline
Although we disagree with the need for banking organizations to revise previous financial
statements, battling the SEC on many of these issues seems not the proper course. They
have an obligation to enforce sound reporting and disclosure practices as best they can, and
our financial markets have been well served in the process. The U.S. banking industry has
its obligations, too, to manage its risks and to tell its story to bank supervisors, the SEC, and
the general public. If for no other reason than the fact that banks today are so large and
complex and have the potential to present such widespread risk, these largest institutions, in
particular, should be held to high performance and compliance standards.
As bank supervisors, we should welcome the market's help to identify and assess banking
risks and to minimize the risk of moral hazard. One approach the Federal Reserve is
exploring would enhance the role of investors in bank or bank holding company
subordinated debt. Unlike shareholders, who benefit from any gains from excessive risk,
subordinated debt holders have only downside risk. As a result, their incentives are similar
to those of supervisors and the bank insurance fund: they lose if the bank defaults but they
don't participate in outsized gains.
A difficulty, however, in creating a greater role for subordinated debt is determining how to
provide investors with adequate and timely information about a bank's risks and with
sufficient leverage to affect management decisions. From the supervisor's perspective,

another difficulty is separating market "noise" in changing yield spreads from meaningful
signals they may provide. We will be collecting and analyzing these data in the months
ahead and will be evaluating their potential usefulness, both as a tool for supervision and as
a market mechanism for providing feedback to banking organizations. Whether or not the
exercise proves fruitful, it points in the right direction--providing incentives for greater
market discipline and for sound management of banking risks.
In closing, I would remind you that we are beginning to see slippage in important indicators
of industry strength. Though still low by historical standards, the volume of nonperforming
assets increased last year for the first time since 1991, with the deterioration concentrated
within commercial and industrial loans. Delinquencies in agricultural loans have also risen,
as a result of extremely weak markets for many farm products. Continued weakness in much
of this sector could begin to weigh on some community banks.
The next stress-point for any particular bank may come from poor credit quality, from
structural and competitive pressures within the industry, or from many other sources.
Fortunately, the U.S. commercial banking system has demonstrated a great deal of strength
and resiliency in dealing with challenges of the past, and it still seems as strong and as well
positioned overall now to handle stress as it has been in many years. I have no doubt that the
U.S. banking system will continue to grow and that it will remain central to the nation's
financial system. To do that, though, requires that we all to adapt to changing times and that
banks manage risk carefully in both good times and bad.
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