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For release on delivery 9:00 a.m. CDT (10:00 a.m. EDT) April 23, 1995 Derivatives, Technology, and Challenges Ahead Remarks by Susan M. Phillips Member, Board of Governors of the Federal Reserve System at the Conference of State Bank Supervisors San Antonio, Texas April 23, 1995 Board of Governors of the Federal Reserve System Comments Before the Conference of State Bank Supervisors San Antonio, Texas April 23, 1995 Introduction. I am delighted to be here to address the CSBS. It is particularly a pleasure at a time when the commercial banking system appears to be so strong. The industry has posted its third consecutive year of record profits; bank capital ratios are near 20-year highs; and the volume of nonperforming assets has been sharply reduced. The strength and competitive posture of the U.S. banking system has implications not only for the country's long term economic growth, but also for the viability and success of the dual banking system. We have seen the types of unwanted responses that can come from regulatory agencies and from the Congress when the condition of the banking system declines too far. We have also seen the kinds of problems that borrowers and local economies can have when their access to credit is interrupted. Such interruptions can occur either because their banks failed or were merged out of existence or because the lender needed to rebuild its own strength. 2 Fortunately, we now seem to be on a different track than we were in theearly 1990s. Washington even seems to have a friendlier attitude toward the banking industry. Future challenges for the banking system more likely may come from sources that are fundamental to the nature of banking and to financial markets, rather than from politicians or even bank regulators. In my remarks today, I want to discuss some of the trends in banking that I believe will challenge both the industry and bank regulators in the years ahead. Certainly I will talk about derivatives-that is an important challenge for us all. But I believe it is time that we put derivatives into the proper context of all the challenges facing the banking industry and its regulators. As we address these challenges, it is important that we work together, hopefully learning from the lessons of the past. Technology and Innovation A principal challenge—and a source of new opportunity-is technology and financial innovation. Both directly and indirectly, technology is fundamentally changing the nature of financial institutions and the activities of bank supervisors. These changes affect the prospects for current and potential legislation. 3 One of the more obvious effects of technology has been the creation and tremendous growth of securities activities and derivatives products and the increased importance of managing market risk. Not only large banks, but many small and medium-sized institutions, have turned increasingly to derivatives, structured notes, and securitized products in an effort to manage risks and to enhance their returns. In large part, this trend is good. Despite the highly visible problems of some investors and traders, the Federal Reserve has consistently argued against legislation that would restrict or discourage the use of derivatives. We believe derivatives are useful products that can help bankers manage risk. By providing risk management tools, derivatives fundamentally help promote economic efficiency and real growth. Because of the leverage and complexity of these instruments, however, they can also create significant risks if improperly used. The key, as several unfortunate experiences demonstrate, is to understand and manage the risks appropriately. Toward that end, the Federal Reserve and the other federal banking agencies have issued a number of policy statements designed to improve the management of risks in new, more complex financial 4 products. In 1993, both the OCC and the Fed issued guidance regarding bank- use of derivative instruments. A few months later, the Fed also distributed an extensive trading activities manual to its examiners and to the large trading banks. Last year, all three federal banking agencies--and the OTS as well --issued further guidance regarding the risk of structured notes. All of us highlighted the risks in these products and emphasized the need for banks to analyze the risks carefully before making purchases. In our guidance, the Federal Reserve has emphasized the management of activities and risks, rather than the management of product lines. Banks should manage the underlying risks, regardless of what an instrument is called. That approach seems most sensible to us, especially in an era of rapid innovation. Whereas our 1993 guidance focused on trading activities, a companion statement issued late last month focused on investments in securities and the management of derivative products held by end-users. There are notable differences between the two documents, but both stress the same underlying principles: 5 (1) The need for boards of directors and senior management to be informed and actively involved in the risk management process, and (2) The need for adequate policies, information systems, and procedures for measuring and controlling risk. Day by day, the business of banking and the practice of risk management become more complex. Banks and other financial institutions have adapted by developing increasingly more sophisticated methods for measuring risks. Supervisors are adapting, as well. Evidence of this supervisory evolution can be seen in the structure of recent regulatory capital proposals incorporating market risk. Less than two weeks ago, for example, the Basle Committee on Banking Supervision issued for comment proposed capital standards for trading activities of internationally active banks. An important element of that proposal was the alternative it offered for banks to base their capital standards on the results of their proprietary models. This offer to accept internal models is precedentsetting for bank regulation and acknowledges the complexity of bank activities and the advances some in the industry have made in measuring and managing risks. 6 Nevertheless, when developing the standard, supervisors believed that it • was necessary to place some restrictions on the modelling process in order to achieve the required level of rigor and consistency among banks. But even in developing the standard, the restrictions were designed to be as compatible as possible with the industry's own risk management procedures. A similar approach was taken in the domestic proposal for measuring interest rate risk that was issued for comment in September, 1993. As with the recent Basle initiative, that IRR proposal also offered banks the use of their internal models. Indeed, that 1993 proposal may have helped pave the way for the international agreement that proposes the use of internal models for trading accounts. The IRR measure is still being finalized, but it should be issued sometime this summer and will continue to offer a significant role for bank internal models. As we go forward, we might see more supervisory and regulatory techniques that rely upon a bank's own evaluations when we can be satisfied that a bank has sound management practices in place, including internal controls and risk management systems. This approach stresses that the responsibility 7 •rests with management to design and enforce sound policies, practices, and controls. I believe that is the only approach that can work in the long run. Supervisors need to understand the risks and ensure that the bank's practices and procedures are appropriate and consistent with its activities. Thus, increased emphasis must also be made simultaneously on improvements in the quality of disclosure, regulatory reporting, and even accounting data. But the focus should be on making sure that the banker is doing the job well, not on second guessing bankers or dictating detailed management procedures. That approach, which avoids micro-management, seems more practical, even necessary, with the advance of technology and the growing sophistication of risk management techniques. The Basle proposal that I mentioned illustrates the kind of risk measurement techniques available to banks as a result of advances in portfolio theory, financial pricing models, and technology. In this case, the modelling technique relies on a concept known as "value at risk." This is a statistical term that identifies the maximum loss that one might expect to incur from a particular portfolio during a specific period of time with a specified level of statistical 8 confidence. For example: "I can say with 95 percent confidence that the bankwill not lose more than $10 million on its existing trading portfolio by close of business tomorrow." To be able to make that statement, the banker must know the bank's exposures--in a timely manner and in detail, and must also have information about the historic volatility of relevant market rates and prices and, depending upon the nature of the model, even their correlation. Of course, the bank also needs a modelling system to pull it all together. Such complex and data-intensive calculations produce a much more accurate measure of risk than some of the traditional standardized "rule of thumb" approaches to risk and capital management. Such techniques, though, require a good deal of computing power, but that aspect is becoming less of a problem every day. I recently read that if, during the past 30 years, Detroit had kept pace with Silicon Valley, a new Chevrolet would get 2,000 miles/gallon, cruise at 7,500 miles/hour, and cost 12 cents. Today, and more so in the future, banks must be able to process and evaluate information ever more efficiently. 9 Better Analysis of Credit Risk While banks, at least the largest ones, are applying complex statistics and risk measurement techniques to market risk, much more needs to be done with credit risk, which remains the principal risk for most commercial banks. The difficulty in this area centers around the availability of data. Decades of data are readily available about the market prices for stocks, bonds, and foreign exchange rates. But there is virtually no comparable database for loans-at least not for loans to small unrated companies, which are the principal business customers of small banks. With the ever-increasing power of computers, one way or another, more needs to be done bv the industry to improve the efficiency and effectiveness of the lending process. I do not mean necessarily improvement with respect to the administrative procedures of processing and documenting loans, but rather with the process of analyzing and pricing credit risk. Otherwise, banks will continue to repeat the same mistakes of reducing prices and credit standards in good times and then suffering when the bad times come. Unless progress is made in this area, bankers will become more and more vulnerable to nonbank 10 competitors who are more willing and able to distinguish between different levels of credit risk. By their nature, banks operating in small communities tend to know more about the character and personal characteristics of their current and potential customers than do larger banks operating in large urban areas. That has been a fundamental strength of the small bank, and one that has helped it to compete effectively, so far. However, this traditional advantage may be eroded by technology and the increasing capability of larger institutions to harvest available information for all that it's worth, and to use that information for their marketing, credit scoring, and risk management efforts. It is important that banks of all size keep alert—not to resist the inevitable march toward more efficient financial markets, but to remain responsive to a customer's condition and needs. Pressures on Operating Costs Growing competition has placed a great deal of pressure on banks to reduce operating expenses and to economize. Since 1990, the number of commercial bank employees in the United States has fallen by 2.0 percent-that's 30,000 11 jobs. The number of commercial banks has declined much more--by 15 percent, or almost 2,000 institutions. Meanwhile, bank assets have increased by 18 percent. The result of all of this is greater productivity in the banking system, but it is also pressure that I'm sure all of you feel. Moreover, it is pressure that is not likely to diminish in the next few years, with the removal of interstate branching restrictions and with further erosion of barriers between securities firms and banks. Many of you will continue to feel pressure to reduce or minimize costs. Such steps may be necessary, but they can also present potential pitfalls, as banks—like so many other industries today-try to restructure their operations. Cost cutting presents a particular challenge for all of us-banks and supervisors. If institutions are too ruthless in cutting costs, they may undermine the loyalty and the commitment of their remaining employees. All institutions need officers and staff who are willing to make a commitment and whose goals and philosophies are consistent with their own. As a central banker and a bank supervisor, I have seen many cases where institutions failed—and even where 12 markets were jolted-because employees were poorly trained, supervised, or committed to their work, or because executives, themselves, had only short-term, self-interests in mind. In the months and years ahead, federal and state supervisors will need to revisit their own operating structures as interstate branching begins to kick in. How we respond to this fundamental change in the structure of the banking system can have important implications for the future of the dual banking system. National banks could have a material advantage if their supervisory and application procedures are much more streamlined than those for state-chartered banks. State and federal supervisors must take appropriate steps to ensure that our own procedures are not excessive and that we do not have redundant, inefficient, and costly exams. Conclusion On behalf of the Federal Reserve, I look forward to the next few years as we deal with the challenges ahead. We are likely to see banking legislation that we want and to experience further gains in technology and financial innovation. This is an excellent time for banks to reassess their goals and future prospects 13 and to ask themselves how they can best deal with the challenges, make an adequate return, and meet their customers' needs. Supervisors clearly have some planning and coordinating to do of their own. The balance sheet and general financial strength of the U.S. banking system is stronger now than it has been in decades, and the economy-while slowing—is still relatively strong. It may be tempting to let credit and other operating standards slip, as has happened at such times in the past. I hope we can all learn from the mistakes of the past and move forward to take advantage of advancing technology and financial innovation. This will not only set the stage for more record earnings in the years ahead, but also provide the opportunities for that growth to be sustainable. Thank you.
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