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For release on delivery
1:00 p.m. EST
February 25 , 1994



Remarks of
Susan M. Phillips
Member, Board of Governors of the Federal Reserve System
at the
Conference on Financial Markets
Federal Reserve Bank of Atlanta
February 25, 1994
Coconut Grove, Florida

I am very pleased to have an opportunity to participate in
this timely program organized by the Federal Reserve Bank of Atlanta.
The conference has been focusing on issues relating to price
volatility, risk management, and derivatives.

These issues have been

the object of intensive study and debate for several years, and there
is no end in sight to this ongoing analysis.
In the next few weeks the General Accounting Office is
expected to release its long-awaited study of derivatives.


congressional committees appear poised to call hearings once the study
is released.

Congressman Jim Leach of Iowa, the ranking minority

member of the House Banking Committee, already has introduced
legislation targeted at derivatives.

His bill would create a new

Federal Derivatives Commission to coordinate the regulation of
derivatives activities and perhaps also to expand significantly the
scope of such regulation.

Others in Congress reportedly are

developing their own proposals for legislation in this area.


upcoming reauthorization legislation for the CFTC could also focus on
derivatives issues.
Both the studies and the legislative proposals reflect
concern (and, in some quarters, alarm) about the implications of the
rapid growth of derivatives.

This concern is focused both on risks to

individual dealers and end-users, particularly federally insured
banks, and on the stability of the financial system as a whole.


growth of derivatives activities undeniably poses challenges to
dealers and end-users and to regulators.

I believe these challenges

are manageable, but major efforts will be required by all involved.
As we move forward, however, we must not lose sight of the
benefits of the growth and expansion of derivatives activities.


obvious b e n e f i t s of the n e w i n s t r u m e n t s are the i m p r o v e d o p p o r t u n i t i e s
to t r a n s f e r v a r i o u s market



I b e l i e v e the m o s t

b e n e f i t s of d e r i v a t i v e s u s u a l l y are o v e r l o o k e d .


The c o m p l e x i t y of

d e r i v a t i v e s a c t i v i t i e s , along w i t h the i n t e n s e scrutiny t h e s e
a c t i v i t i e s have a t t r a c t e d ,

are forcing a r e v o l u t i o n in risk m a n a g e m e n t

The p r a c t i c e s and t e c h n i q u e s that must be i m p l e m e n t e d

d e r i v a t i v e s a c t i v i t i e s are to be placed


on a sound f o o t i n g have the

p o t e n t i a l to e n h a n c e s i g n i f i c a n t l y the s o u n d n e s s and e f f i c i e n c y of
m o r e t r a d i t i o n a l t r a d i n g and lending a c t i v i t i e s .
In the next few m o n t h s b a n k i n g r e g u l a t o r s w i l l be c o n s i d e r i n g
the t r e a t m e n t of d e r i v a t i v e s and other t r a d i n g a c t i v i t i e s in

capital and

financial reporting standards.

I see t h e s e

r u l e m a k i n g s as o f f e r i n g o p p o r t u n i t i e s to p r o v i d e b a n k e r s w i t h
i n c e n t i v e s to adopt m o r e w i d e l y and to

refine the n e w risk m a n a g e m e n t

p r a c t i c e s that have begun to be i m p l e m e n t e d by the

S e i z i n g t h e s e o p p o r t u n i t i e s w i l l not

leading derivatives

r e q u i r e any n e w

l e g i s l a t i o n but w i l l require r e g u l a t o r s to adopt n e w a p p r o a c h e s to key
r e g u l a t o r y issues.
In m y remarks today
t h o u g h t s on the

I would

like to d e v e l o p m o r e fully my

r e v o l u t i o n that is t a k i n g place in risk m a n a g e m e n t

role of d e r i v a t i v e s in that


I w i l l then turn to some

p o s s i b l e c h a n g e s in a p p r o a c h to r e g u l a t i o n and
changes could



how t h e s e

reduce the risk and e n h a n c e the e f f i c i e n c y of i n d i v i d u a l

banks and of the f i n a n c i a l system as a w h o l e .
D e r i v a t i v e s and the R i s k M a n a g e m e n t R e v o l u t i o n in B a n k i n g and F i n a n c e

someone who came from a w o r l d w h e r e

h e d g i n g w e r e part

of n o r m a l b u s i n e s s


risk m a n a g e m e n t


I h a v e b e e n curious

about the s k e p t i c i s m r e g a r d i n g b a n k s ' use of d e r i v a t i v e s .

I have

concluded that the concerns that have been expressed about derivatives
by legislators, regulators, and even senior executives of financial
institutions can best be understood as symptoms of broader anxieties
about changes in financial markets and, in particular, the roles that
banks are playing in those markets.

During the past two decades,

financial markets and institutions have changed dramatically.


have been transformed by the forces of securitization and

Banks, especially in the United States, have seen the

profitability of traditional business lines come under pressure as the
result of deregulation and innovation, forcing them to develop new
strategies and products in order to earn competitive returns on their
As a result, the risk profiles of banks have been changing.
At the largest banks, in particular, trading activities have been
growing relative to traditional credit intermediation.

Credit risks

have declined relative to market risks and the nature of both of these
types of risks has become more difficult to measure and control.
Credit risks increasingly have reflected credit exposures from
derivatives activities, which can change dramatically as a result of
movements in interest rates, exchange rates, or other market factors.
Likewise, because of the greater liquidity of securities and
derivatives markets and the leverage that many of these instruments
offer, traders today can establish positions that entail substantial
market risks within minutes or even seconds.

Furthermore, the trading

of options, including securities with imbedded options, creates market
exposures that can change rapidly, even in the absence of new
transactions, as a result of price changes or changes in expected
price volatility.

These changes in product mixes and risk profiles are
requiring banks and other financial institutions to develop new, more
powerful approaches to risk management.

These new approaches have

been made possible by advances over the past twenty years in data
processing technology and, perhaps even more important, by advances in
financial economics.

The publication twenty years ago of the Black-

Scholes options pricing model clearly was a watershed.

Since then,

product innovations and theoretical innovations have fed off one

The proliferation of derivatives has allowed the risks

associated with traditional financial instruments to be unbundled and
separately priced and managed.

At the same time, the offering of new

generations of exotic derivatives has been facilitated by analyzing
and pricing them as combinations of fundamental risk factors.
The cumulative effect of these efforts to rationalize the
pricing and management of risks in the derivatives businesses of the
leading banks and securities firms has been to set the stage for a
revolution in risk management.

This would include new approaches to

the conceptualization, measurement, and control of risk.

The key risk

management practices and principles involved are outlined in a study
that was produced by practitioners and published by the Group of
Thirty last summer.

Market values rather than book values are the

starting point for defining and measuring risk.

Risk is defined as

the potential for a decline in the market value of a financial
instrument or portfolio of financial Instruments.

It is measured by

examining historical movements in the values of fundamental risk
factors and simulating the effect of such movements on the relevant
market values.

Heightened attention is paid to concentrations of risk

and the potential for diversification that is suggested by historical

correlations among risk factors.

Building on this conceptual

framework, risks are controlled by the consistent application of
position limits based on the results of potential loss simulations.
Because of the leverage and liquidity obtainable through trading
derivative instruments, considerable emphasis is placed on the
reliability of these internal controls, including the assumptions
underlying the simulation models.

They are monitored and enforced by

specially trained risk managers who operate independently of the
traders and report directly to senior management.
I believe that the pricing of financial instruments and the
management of the component risks by these new methods have the
potential to enhance the safety and soundness of financial
institutions and to produce a more efficient allocation of financial

However, the methods involved are as complex as the derivative

instruments themselves.

More important, the systems needed to

implement these methods are very costly, especially for firms that
have multiple product lines and offices in numerous geographical

Thus, even for the largest and most sophisticated banks

and securities firms, implementation of these methods poses
significant challenges.

Some firms that have implemented the new

methods in their derivatives business have applied them only slowly to
traditional trading activities, such as foreign exchange and fixed
income securities.

The application of modern financial methods to the

pricing of loans and the management of loan portfolios is still in its

Progress has been retarded by the paucity of reliable data

on market values for many types of loans.

But lending is an activity

that could benefit most appreciably from application of the new risk
management methods.

I say this based on experience in recent years.

First we witnessed a wave of loan losses and bank failures, which owed
largely to concentrations of credit risks that were unrecognized and

Then a period of overreaction followed, in which many

creditworthy borrowers apparently could not obtain bank credit at any
Appropriate Regulatory Responses to the Risk Management Revolution
The risk management -revolution that has been made possible by
the development and expansion of derivatives activities also poses
challenges and creates opportunities for regulatory authorities.


changes that are occurring in the risk profiles of regulated entities
and in their risk management practices clearly require changes in
supervisory and regulatory policies and procedures.

In particular,

the increasing importance of market risks in the risk profiles of
those large banks that are now heavily engaged in derivatives and
other trading activities implies a need to review examination
procedures and regulations applicable to such activity.

In doing so,

I believe regulators not only can meet this challenge but also can
create incentives that will place both the newer activities and
traditional activities on a sounder footing.
In my view, the on-site examination of risk management
systems and internal controls always has been a critical element of
banking supervision and regulation.

The recent changes in risk

profiles and risk management practices that I have discussed make the
examination process even more important tbday.

With derivatives and

highly liquid securities, risk profiles can change drastically, not
only, day to day, but hour to hour and minute to minute.-


regulators must devote increasing attention to the process by which

banks manage their portfolios and risk profiles, in addition to the
individual instruments that are held at any point in time.
A bank's decision-making process is embodied in the policies
and procedures established by its board of directors and in the

systems, limit systems, audit procedures, and other

internal "fcontrols that ensure compliance with the board's directives.
All of these elements need to be reviewed in the course of an on-site
examination of a bank.

The Federal Reserve is nearing completion of a

major effort to enhance and consolidate the guidance we provide to
examiners on risk management and internal controls for derivatives
activities and other trading activities.

Last December the Board's

staff sent a letter to examiners that highlighted the key
considerations in these reviews.

The Reserve Banks, in turn,

distributed the letter to banks that have substantial trading or
derivatives activities.

These issues also will be addressed in

significant detail in a Capital Markets and Trading Activities Manual
that is currently being field tested by the Reserve Banks.
I would note that this guidance to examiners is broadly
consistent with the risk management practices recommended by the Group
of Thirty.

Among the common points of emphasis are:

(1) an active

board and senior management oversight of trading activities;

(2) the

establishment of internal risk management functions that are
independent of the trading function;

(3) thorough and timely internal

audits to identify internal control weaknesses; and

(4) risk

measurement and management information systems that include stress
testing and contingency planning for adverse effects of unusual market
conditions, such as prolonged periods of market illiquidity.


examination procedures will need to be continuously updated and

strengthened, I believe that these recent efforts constitute a
significant enhancement of our supervisory capabilities.
A more difficult but equally important task for regulators is
the modification of capital and reporting requirements to accommodate
changing risk profiles and to support implementation and ongoing
refinement of the new risk management practices.

Last April the Board

made available for public comment proposals by the Basle Supervisors
Committee to revise the Basle Accord.

The revisions would recognize

reductions in credit risk from the use of legally enforceable netting
arrangements for derivatives contracts and would incorporate measures
of market risks on foreign exchange and traded debt and equity
positions, including derivatives positions.
While public commenters have been supportive of the netting
proposal, the market risk proposals have been heavily criticized.


the view of many large banks and trade associations, the basic problem
is that the market risk proposal uses relatively simple rules that are
inconsistent in some respects with modern financial economics.


example, the treatment of risks on options positions is crude and
risks are aggregated in a way that is inconsistent with statistical
estimates of how those risks are correlated.

As a result, the

proposals fail to provide incentives for implementation and ongoing
refinement of the new risk management methods.

In addition, the

proposed rules cannot readily incorporate new instruments,
particularly those whose value depends on new underlying assets or

Finally, because of the inconsistencies between the

measurement scheme embodied in the proposal and those being
implemented by the leading financial institutions, compliance with the
proposal would be burdensome.

As an alternative to the proposal, many commenters have
suggested that banks be allowed to use their own internal models to
compute capital requirements for market risk, subject to examiner
review of the models and in accordance with guidelines set byregulators.

For example, regulators might specify that banks should

set aside sufficient capital to cover 95 percent or 99 percent of
potential losses on the trading positions over a two-week holding
period, based on historical movements in market prices over the last
five years.

The banks would then estimate the key parameters (price

volatilities and correlations) that would determine the amount of
capital required to meet the regulatory guidelines.
I admit that I am sympathetic to the general idea of using
internal models to determine regulatory capital requirements.


fact, I strongly supported the U.S. banking regulatory agencies'
proposal to use internal models to determine capital requirements for
interest rate risk.

However, I expect that ultimately regulators will

be reluctant to implement such an approach unless reliable methods can
be developed for examiners to validate banks' internal models.


commenters on the market risk proposal have flagged this issue but
have not offered concrete suggestions on how to resolve it.
Financial reporting is another area in which regulators and
the accounting profession need to develop new requirements that better
reflect the risks and returns from derivatives and other trading

I think nearly everyone agrees that existing disclosures

are inadequate.

The practice of limiting disclosures about

derivatives to notional principal amounts outstanding has even been

It has fed unwarranted fears about the risks that

derivatives activities entail.

U.S. banking regulators have for some


time required disclosure of gross replacement costs, and the Financial
Accounting Standards Board (FASB) has also required disclosure of fair
values and potential accounting losses associated with derivatives.
Both the regulators and the FASB appear to be moving in the direction
of requiring disclosure of both gross and net measures of counterpartycredit exposures and also of positive and negative fair market values
for various types of derivatives contracts.
These new disclosures are a step in the right direction.


particular, they should help place those scary notional principal
values in perspective.

These new disclosures, however, would still

fall short of providing meaningful information on risks and returns
from derivatives and other trading activities.

Consequently, I am

afraid that such activities will continue to be misunderstood and
This is an area in which regulators, working with financial
institutions, the accounting profession, and the academic community,
can and must provide leadership and vision.

The Group of Thirty's

analysis and recommendations on disclosure provide an excellent
starting point.

To be consistent with modern financial economics and

to avoid stigmatizing derivatives activities, that study recommended
that disclosures of trading activities apply to all financial
instruments, not just derivatives.

The recommended disclosures

include qualitative discussions of management's attitude toward
financial risks, how various instruments are used, and how risks are
monitored and controlled.

Although the report shows signs of a

vigorous debate among practitioners on the desirability of disclosing
quantitative measures of market risk, the report stopped short of
recommending such disclosures.


I believe qualitative disclosures of the type recommended by
the Group of Thirty would be extremely valuable.

As I have discussed,

we need to focus more on the process by which risks are assumed and
managed rather than on the instruments held and the risks assumed at a
point in time.

Quantitative disclosures of risks may be misleading,

especially if they represent a snapshot of an institution's risk

Nonetheless, I believe quantitative disclosures of market

risks need to be developed and implemented, perhaps based on
simulations using internal models (estimates of so-called value at
risk) or on the historical volatility of the market value of trading
Judging from the Group of Thirty's report, the principal
arguments against such disclosures are that they could be unreliable
and might be too sensitive to reveal to competitors.
clearly is a critical issue.


But if output from internal models is

not sufficiently reliable for public disclosure, I question whether it
is sufficiently reliable as a basis for regulatory capital

And if market values are unreliable, the new risk

management systems as a whole are built on a shaky foundation.


regard to the competitive sensitivity, these concerns seem overstated.
The types of aggregate portfolio measures discussed in the Group of
Thirty's study would tell competitors nothing about specific
instruments or positions held and, therefore, would do nothing to
jeopardize an institution's profits or expose it to losses.


important, without disclosure of such quantitative measures, I fear
that institutions with substantial derivatives activities will
continue to be plagued by highly exaggerated views of the risks of
such activities.

As you have heard, I believe that both financial institutions
and regulators have made substantial progress in meeting the
challenges posed by recent changes in financial markets and risk
profiles, including the expansion of derivatives activities.
Nonetheless, if we are to take full advantage of opportunities to
strengthen risk management practices for both derivatives and more
traditional financial activities, we have more work ahead of us.
Working together, I believe financial institutions and their
regulators can meet these challenges.

Moreover, the persistence of

what appear to be exaggerated fears of the risks of derivatives
activities makes it essential that this work be completed