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For release on delivery
1:45 CET (2:45 EOT)
Saturday, October 19, 1985

Safety, Soundness, and Self-regulation
Presentation by
Preston Martin
Vice Chaiman
Board of Governors of the Federal Reserve System
to the
American Barkers Association
Annual Convention
New Orleans, Louisiana
October 19, 1985

Safety, Soundness, and Self-regulation
Presentation by
Preston Martin
Vice Chairman
Board of Governors of the Federal Reserve System
to the
American Barkers Association
Annual Convention
New Orleans, Louisiana
October 19, 1985

In our time it has become fashionable to emphasize the stresses and
strains in our society and almost embarrassing to suggest publicly that
adjustment and evolution might possibly turn out well.

Of course it is

necessary to recognize our problems and our perils— much of today's
economic landscape is terra incognita.

For our society as a whole, our

institutions and our markets — and for banking specifically, your
competitors and even your products — are transformed, not just changed.
Yet it is a sign of the fundamental soundness of our financial system that
while individual institutions have suffered, the system and the economy as
a whole have remained healthy.

That is not to say that we should not be

concerned or lessen our vigilance.

What do we really know about the risk

potential inherent in swaps, options, standbys, indexes, options on
indexes, backups, and all of the other innovations of those bright MBAs?
It seems almost impossible to draw a firm line between prudent, yet
high-return, investments and speculation.

My argument is with a superficial idea of our age:

that only a tragic,

pessimistic view of events is "serious" and "analytical".

Instead let us

keep in mind the risks we run tut recognize that financial institutions in
most instances have made some necessary adjustments which have turned out

well.

We are not always truly in crisis — at times we are simply

witnessing the end of "closed systems" in a deregulated, global
environment.

The financial industry is serving its publics better with a

diversity of products and better rates of return.
banks and thrifts have failed.

Certainly numbers of

But, in most cases, failed banks have

reopened under new management or have become branches of other banks and
are continuing to serve their communities.

One effect of disinflation, deposit deregulation, diversification, and
even deflation in commodities, farm land, some housing, and some foreign
assets is the recognition that you, and we, need to focus attention and
resources on asset quality.
them".

I know, "they were all good loans when we made

Let me suggest that the three Rs today for asset portfolio

management are review, review, and re-review.
market change is not reregulation.

I submit that the price of

Rather it is improved governmental

supervision and more effective management, including some form of
self-regulation.

I am very much aware that the barking industry has taken considerable
steps to improve the quality of its loan and asset portfolios.

I observe

with satisfaction changed thinking in risk management, the designation of a
more senior executive, a senior management group, and a board committee to
control the review of credit decisions.

This particular function is so

important that we and you must carefully analyze those controls.

But,

while our concern is mainly with the industry as a whole, bank management

3

and director responsibility is with the individual institution.

To place

the burden where it belongs, bank management and directors are ultimately
responsible for ensuring strong profits, good asset quality, and sound
operations.

I would emphasize that responsibility in today's environment,

in which insurance coverage for directors is not always easily available.
In addition to an effective system of internal controls, you should look to
your internal auditor and your CPA firm who are in a strategic position to
render you assistance in your evaluation of procedures, policies, and
objectives which lead to high quality assets.

I recognize that banking is not the securities business nor the
accounting profession.

The culture of the industry, its competitiveness,

and the basic requirement of customer confidentiality make banking unique.
However, I think the time has come to marshal private resources as well as
governmental ones to arrest the erosion in public confidence which
newspapers and pollsters have noted.

Other industries have found that the

exchange of information about good practices, risk controls, workable
remedies to problem situations, and even codes of ethics, can coalesce to
form a structure to educate the public and the slow learners in management.

Banking will continue to evolve swiftly in a regulatory environment
which has shifted away to some degree from the premise that government has
all of the answers.
market.

Our society has rediscovered the efficiencies of the

Neither excessive risk-taking nor undue timidity are rewarded for

very long.

We need to balance these two opposing forces.

Reasonable

4
innovation, risk-taking, and growth need to be encouraged without fear that
minor disturbances will lead to a public cry that the sky is falling.

On

the other hand, we should strive for a stronger, self-reliant system, which
is less dependent upon the safety net and which recognizes that confidence
in the banking system is the industry's most valuable asset.
ultimately impose a discipline on economic activities.

Market forces

However, we cannot

rely on the marketplace alone to balance the competing factors of risk and
reward.

Indeed, our current banking statutes and policies recognize that

no such single-minded reliance is possible, particularly should confidence
in the banking system falter.

We are seeing the distinctions between banks, investment firms and
businesses blur.

While these will always be, in my opinion, separate

institutions, at the edges there has been, and will continue to be, intense
competition.

The entry into banking activities of retailers, Wall Street,

and insurance firms has affected gross margins as new financial instruments
are developed to attract consumers.

Obviously, the public has benefitted

from competitive forces, but the responsibility government officials have
over banks, thrifts, and other financial institutions requires us to
examine more carefully what changed circumstances portend for capital
adequacy and liquidity.

In today's environment, it is imperative that the

examination approach allocate more resources toward measuring and analyzing
the quality of assets and somewhat less toward the most technical aspects
of compliance.

This is not to slight efforts with regard to potential

5

conflicts of interest, market concentration, financial disclosure, or
consumer protection, but to reallocate priorities in your and our review
processes.

Today's dynamic environment demands greater regulatory focus upon
quality control, demanding increased roles from senior management, internal
auditors, and CPAs.

There must be an increase in the number of qualified,

experienced auditors and supervisory examiners.

Information management

techniques need to be accentuated to delimit the scope of examinations to
areas of particular risk.

Also, the accounting profession needs to assume

more of a quality asset-testing role, one which will give top management
better information as to relative risks and as to risk control procedures
within an audited institution.

As you know, we have recently adopted new policies to help both you and
us — the regulated and the regulators — to evaluate risk.

The experience

of recent years compels us to increase our surveillance in order to
anticipate problems at an earlier stage, improving the chances for
recovery.

The effects of two recessions, disinflation, increased

competition, inadequately reviewed business judgment, and, in a few cases,
misuse of the public trust, demand increased vigilance.

In general, we

intend to increase the frequency of our examinations and correct weaknesses
through more frequent and clearer communication with bank management and
the directors who are responsible for the activities of their institutions.
We are also looking into other areas of supervision:

upgrading our

6

coordination of efforts with other banking supervisory agencies, both state
and federal, to improve efficiency; sharpening our analytic approach to
deal with issues such as bank holding company funding and liquidity, and
risk and leverage considerations in nonbank activities; and improving
examiner training.

I deliberately link the thoughts of examination and responsibility
because while we supervise over 6,200 bank holding companies and 1,100
state-chartered banks, the responsibility for those individual institutions
rests with bank management.

This is a fundamental principle which often

seems forgotten in a era of increased reliance on outside examinations.
The public turns to the regulatory agencies demanding to know why we are
not doing a better job of supervision.
that direction.

As I noted, we are taking steps in

But our resources are not infinite nor do we want to

impose an undue burden on the banking industry by determining the worth of
every bank activity and decision.

Also, I argue that the accounting profession must assume a larger
quality asset and quality control testing role, one which will give Boards
of Directors, Board Committees and top management better information as to
high relative risks, and asset concentration relative to internal controls
within the audited institutions.

In such an uncertain economy, risk

exposure has gone so far that even the control augmentations that I have
enumerated may not be sufficient.

Thus I continue to advocate that the

banking industry and the regulators seriously approach the feasibility of

7

some supplementary form of self-regulation.

It is time that all of us

consider how the known, short-run trends in risk taking can be delved into
to achieve a new quality of risk management and how the industry can better
share vital information and analyses.

A key safety and soundness issue centers around the difference between
preventing and detecting problems.

Increasingly, examiners operate in a

"detect" mode; problems are identified after the fact.

How do we train

examiners to keep abreast of new business areas where risk exposure is
arising?

In order to grow and to counter the pressures of narrowing

margins or spreads, some financial organizations have increased their
exposure to risk to reach for yield.

Faced with increasing competition,

even global competition, some have entered new fields or are accepting new
and greater risks in their fundamental businesses to generate income.
Others have greatly broadened the geographic base of their operations.
This results in an environment of heavy competition, much uncertainty, and,
in a few cases, outright failures.

This situation accentuates the need to

prevent problems, and the industry is in a position to contribute to that
goal through the spread of good practices and control procedures.

We have seen recently where the problems of a few become the problems
of the many and, as a result, questions arise as to the safety and
soundness of the entire financial system.

Public confidence is a major

issue in the whole process and it behooves the industry to take action to
instill confidence and gain control of its destiny.

During recent

8

scattered setbacks in a few institutions it has become more evident that
efforts to obtain new powers need to be accompanied by industry initiatives
that ensure those powers will be managed prudently.

I believe there have been substantially salutary effects from
self-regulation employed in the securities industry, the CPA profession,
and the nuclear power industry.

Although each is structured differently,

there is clear benefit to drawing from knowledge within those industries.
As an example, look at the New York Stock Exchange, and to the accounting
profession with regard to self-regulation.

While the Exchange maintains a system for regulating and monitoring its
member organizations, the process of self-regulation begins with the
members themselves.

It is the members, through the governing machinery of

the Exchange, who impose rules of conduct upon themselves.

The Exchange

then publishes the standards and requires member organizations to apply
them.

Self-regulation is administered by a professional staff at the

Exchange.

Rules are adopted by the Exchange's governing board, comprised

of representatives of the securities industry, the public, and its
president and chairman.

A special surveillance committee of the Exchange's

Board of Directors keeps watch on any troublesome situation and helps
devise remedies.

With regard to the public accounting profession, it has managed to
maintain its independence and integrity through self-regulation.

The

9

methodology includes establishing professional standards for quality
control, and testing each firm's compliance with those standards.

The

strength of this peer review process lies in its reach, at one time or
another involving every major accounting firm.

What can we learn from these self-regulatory success stories that we
can apply to the banking industry?

I have argued for the need for a

self-regulatory body or bodies in the banking industry that would interface
with the regulators, possibly through the coordinating group of regulators,
the Federal Financial Institutions Examination Council.

There are numerous

functions that could be carried out by the self-regulatory groups.

I would

like to mention a few that I feel require further consideration.

A banking principles board could be established to set standards for
good business behavior, particularly in new business areas, and focusing on
the off-balance sheet products such as interest rate swaps, letters of
credit and so forth.

The growth in asset-backed securities strongly

suggests that the industry set its own standards and guidelines for
securitized investments.
standards are needed.

Operating, valuation, validation, and insurance

For mortgage-backed and chattel mortgage-backed

securities what methods of analysis are most effective? Additionally a
code of ethics could be established that would apply on an
organization-wide basis to individual institutions.

While many banks have

a code of ethics, an issue to be addressed is what types of corporate
culture and behavior encourage improprieties.

This requires a commitment

10

by senior management to establish a corporate climate that emphasizes
ethical conduct.

A self-regulatory group may wish to consider a bank or banker
accreditation program.

Banks whose management choose to do so could be

measured against a set of good practices standards.

Individual banker

accreditation, on the other hand, would involve formalizing an education
process, particularly for young bankers, followed by certification tests.
Such educational requirements might also call for a continuing education
requirement.

Within the self-regulatory group or organization, a clearing-house
could be established for the discussion of problem situations on a
confidential basis.

This would permit institutions with particular

difficulties to have a forum to which they could go to discuss problems as
they are arising and not after unfavorable results have occurred.
about a "safety net" for liquidity situations is one example.

Lessons

This feature

also would benefit bankers by makiirg a source of information available
against which to test their decisionmaking process.

An industry self-regulatory group could help establish business plans
and strategic planning as necessary aids for banks and thrifts staying
viable today.

Long-range strategic planning provides the goals for the

institution, the critical success factors, the action steps assigned by
person and by completion date, and the critical assumptions underlying the

11

goals and success factors.

It is, in short, the plan or road map for the

future of the institution— lacking this, we have seen institutions become
sidetracked from their fields of expertise.

Business plans are the

outgrowth of the planning and research used for the strategic plan and are
much more detailed.

With the business plan addressing key areas— such as

economic environment; growth, profitability, and net worth; continuity of
management and directors; lending, investing, and funding activity and
territory; interest rate risk management; and controls— financial
institutions would have a management tool to measure quality performance
against benchmarks and would be in a position to improve the direction of
their business.

The industry, as a whole, has many good examples to rely

upon as a basis for setting standards for use by institutions of all types
and sizes.

The establishment of good practices standards and a code of ethics
require a mechanism that results in some form of enforcement.

The

self-regulatory body that would be established may be part of an existing
trade organization or trade organizations, or it may be an independent
entity, or it may occur originally as a spin-off of an existing
organization.

Bank accreditation reviews could be performed by the

self-regulatory body itself, or by bank directors, bank general counsels,
independent panels of bankers, or CPAs, who could report to the
self-regulatory body or bodies.

12

Mary may be skeptical of suggestions for a self-regulatory approach in
the banking industry.

In fact, we have already had favorable experience in

industry efforts to reduce daylight overdrafts.

I am also very pleased the

American Bankers Association has established a commission on safety and
soundness and that the commission is evaluating the feasibility of
self-regulation in banking. I give my wholehearted support to this
initiative.

Let's recognize that membership in the self-regulatory group would be
on a voluntary basis.

A prestigious certification would enhance a bank's

public image as well as its credibility with its supervisory agency.

Once

established as a viable self-regulatory body, a standards board's
certification could signal ethical and professional compliance to minimum
banking principles, which federal and state examiners could consider in
their examining process.

In general, board certification would carry

sufficient status so that membership would be in the best overall interests
of a bank.

The public would be assured that analytical techniques are

being used to combat undue risks.

I believe that the necessity of more effective supervision in today's
high-risk, high-exposure financial world demands serious consideration of
ways to draw on industry knowledge in measuring the quality of assets in
commercial banking and in the thrift industry. We have arrived at a
crossroads in the banking business, a business which faces a future
considerably different from the past.

New techniques are therefore

13

required to ensure stability on the path to the future.

Hie challenges and

opportunities confronting banks will continue to increase and managements
are and will be stepping up to greater leadership roles in maintaining
safety and soundness in the changing banking industry.

Today's higher risk

financial institution requires new approaches by the examiners.

However,

regulators' efforts in requiring more capital, additional disclosures,
risk-based deposit insurance, and so on, have limitations.

Industry

self-interest, I urge, necessitates bankers' involvement in self-regulation
and other unprecedented solutions.

Let us build upon the countless

successes in the industry and put crisis management in its place — a
necessary but insufficient approach for a growing, healthy industry.