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· eserve


t. Louis

Jtl 2 '7 1995


Geneva, Switzerland
March 14, 1995
Federal Reserve Bank of St. Louis

It is a great pleasure to be here today to share some thoughts on the
opportunities and risks in today's financial marketplace, particularly those associated with
derivatives, an issue very much in recent headlines. Within that context, my remarks will
focus on two broad risk issues: the expanding number and sophistication of financial
instruments and exposure to market risk, and whether changes in the financial system are
altering the character of systemic risk, thereby weakening traditional safeguards. My
specific observations refer, of course, to our experience in the U.S., but the issues clearly
have global application.


The changing nature of the financial industry, especially developments in the
derivative markets, is a theme that has received considerable attention.

As you know, in

recent years many of the largest banks have sought to increase their revenues by
expanding their trading operations and by developing greater expertise in marketing and
trading derivative products. This development, it seems to me, is a natural response by
these institutions to financial and technological innovation and changing market
demands. Large corporations that once looked to banks for financing now have
alternative funding sources and tum to banks principally for other financial services,
including assistance in managing market risks. Banks that have sufficient expertise to
advise, innovate and make markets in complex financial products see this shift as
providing them with new and important sources of noninterest revenues.
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This trend is reflected clearly on banks' balance sheets and income statements.
Trading account assets of U.S. banks, for example, have tripled from $67 billion at yearend 1991 to nearly $200 billion at year-end 1994. Off-balance sheet positions also
continue to grow, whether measured by notional or replacement value, or by the credit
equivalence measure specified by the Basie Capital Accord.

Revenues from trading and derivatives activities have grown commensurately and
were key to helping some large institutions rebuild their earnings and capital as they
recovered from credit-related difficulties of the past. 1993 revenues were particularly
impressive, but rising interest rates caused most large trading institutions to experience
sharply lower trading revenues in 1994. Nevertheless, the growing importance of tradingrelated revenues to overall profitability of many of the larger banking institutions is

I think most of us would agree that the innovation of recent years is a good thing.
The ingenuity that is the engine of such innovation truly is the industry's greatest
strength. The development of new financial instruments and financing techniques has
expanded the choices of savers and investors, reduced the costs of financial transactions,
improved the allocation of financial resources, increased the competitiveness and
efficiency of financial institutions and financial markets, and opened new avenues
through which individuals and institutions can better diversify and hedge their risks.
These are all welcome developments that should be encouraged.
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Too often, they are


overlooked by people making broad generalizations about derivatives and banking

Having said that, there is also little doubt -- at least in my mind -- that financial
and technical innovation have also introduced new and highly complex elements of risk,
increased the speed and volatility of financial markets and, in so doing, probably
increased systemic risk. Financial service firms, eager to meet identified needs of
customers and to reach for market share, too often create and market new products
without fully considering the risks and potential consequences.

Nearly every day we hear

about a new financial product or a new twist on an old product, and each of these
products carries with it risks that are as yet unknown.

Indeed, events of the past year suggest that the gap between the types of products
and strategies in relatively common use and the capacity of many financial market
participants to handle them has grown. By capacity I am referring to the nature and
quality of risk measurement and management systems, the rigor and effectiveness of
internal controls and, above all, the decision making and management supervision
process. Concern about this gap applies to dealers and end-users alike.



Recent U.S. experience with structured notes and the sizable losses incurred by
some investors in these instruments sound a warning bell for all of us. As you may


know, structured notes are sophisticated debt securities whose cash flows are
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determined by an embedded option or by a formula based on one or more market
indices. These features allow an underwriter to customize the note for an investor -- that
is, to introduce a risk/return profile that is not offered by a standard floating- or fixedrate debt security. It pays to look carefully at just what the "structured note" problem
and other derivative trading strategies are telling us about risk and competition, and the
challenges that face participants in our financial markets today.

The first lesson is that the traditional focus on credit risk may have provided
investors in these instruments with a false sense of comfort about the overall risks
involved. Insufficient attention seems to have been paid to market risk and inadequate
resources devoted to information systems capable of properly identifying and monitoring
market risk. In some cases, such as the Orange County municipal investment pool
debacle, for example, there are also questions about the adequacy of disclosure of
information on asset valuations and investment practices and whether sufficient clues
about potential financial difficulties were provided.

The second lesson, which both the Orange County episode and the recent collapse
of Barings poignantly illustrate, is that low probability events can have devastating,
indeed fatal, consequences.

These events should change the way industry participants

and central bankers think about risk management.

More than ever before, it is critical

that a financial institution's internal safety net -- its risk management and internal control
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systems -- keeps pace with all the various risks presented by a dynamic financial
environment, regardless of the institution's size.

With this in mind, there are several goals that every major financial institution
should embrace in the near-term:
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First, the development and continuous enhancement of measurement and
monitoring techniques for all types of risk, including market risk and credit
risk resulting from either traditional lending activities or more complex
trading and derivatives. The comprehensive assessment and management
of risk is what good and effective risk management is about and is essential
for effective stress testing and contingency planning capabilities.


Second, the development of a fully independent risk management staff and
a strong internal control environment.

It is essential that skilled personnel

are hired not only for the trading floors and risk management staffs, but
also for back office internal audit functions. In this regard, pay scales and
other rewards for these staffs must be made more comparable than I
believe is the case today at most institutions.



Third, is the critical assessment by the board of directors and senior
management of an institution's appetite and tolerance for risk, and
ensuring that risk management and internal control systems are
commensurate with that level of risk. Well-identified and well-used
internal communication mechanisms and a clear pathway straight up the
chain of command are essential.


Fourth, and equally important, is the monitoring of the institution's
financial performance, in context of its actual risk profile. This requires a
sound, comprehensive, but readily understandable, management reporting

With the aim of promoting these important goals at banks headquartered in the
New York area, supervision staff at the Federal Reserve Banlc of New York have for
some time held a series of meetings with officials at several money-center institutions to
discuss several trading- and derivatives-related issues. Based in part on these discussions,
we believe that the banking industry -- working together -- must strengthen its collective
risk management and internal control systems, including related accounting, reporting
and disclosure practices. In this effort, we look to the major market participants to play
• a leadership role in helping to define the best practices for the industry. The derivatives
study by the Group of Thirty issued over a year ago was an excellent starting point.
Also, a voluntary Code of Conduct addressing key risk management, internal control and
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market and sales practice issues has been drafted and currently is under consideration by
various financial market industry groups. I commend both of these initiatives.

Regarding the credit-related risks of trading, we are encouraging the large banks
to enhance the measurement and monitoring of the credit exposures that arise from their
trading activities. This includes both refining the measurement of potential credit risk
and the daily monitoring of that risk. Given the size and complexity of these banks'
derivatives businesses, we believe a state-of-the-art reporting system capable of
monitoring both actual and potential credit exposures on a daily basis is essential for
appropriate credit management and to the development of effective stress testing and
contingency planning capabilities. We understand that efforts are currently being made
at many of the large trading banks to develop systems for the daily monitoring of actual
~d potential credit exposures.

Such strong credit monitoring systems are critical to managing the recent rapid
growth in trading-related credit exposures. Given the potentially global repercussions of
large, unanticipated credit problems brought on by market losses -- the recent collapse of
Barings is a stunning example -- it is essential that banks be able to monitor their actual
and potential credit exposures across businesses and counterparties on virtually a real
time basis. The Barings problem demonstrates how quickly losses from market risks can
give rise to credit risks at counterparties.

This is true notwithstanding that the credit

supporting the trading may involve margining and collateral agreements.
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agreements can, of course, help to mitigate and manage credit risk when customers lack
publicly disclosed or audited financial statements and when the customer's portfolio is
actively managed and constantly changing. However, for margin agreements to be fully
effective in controlling risk, the underlying credit process must reflect the same strong
internal checks and balances found elsewhere in the bank and effective collateral
monitoring systems must be in place. [t is our view that rigorous stress and contingency
testing are crucial elements of managing credit and market risks to which banks should
devote more attention, especially in light of the often sudden and severe impact on
market prices of singular and unexpected events.

Our review last year of the current margining practices at a number of the major
U.S. banks that we oversee suggested that there was room for improvement.

To this

end, we communicated with the major domestic and foreign banks in the New York area
. . urging them to review their credit monitoring systems for their institutional customers
and to satisfy themselves that those systems are founded on sound and effective credit
and internal control practices. We have been pleased with the responsiveness of these
institutions to these issues and we continue to monitor that progress.

Regarding public disclosure, it is my view that there is an urgent need to achieve
dramatic progress toward enhancing the information av_ailable about major market
participants -- and here I would go much farther than most and include any large market
Federal Reserve Bank of St. Louis

Moreover, I am convinced that we have within our grasp


the analytical tools to achieve this needed progress. The same analytic tools used by
financial firms for internal risk management purposes are also of potential value in
providing a clear external picture of ·the risk profile of a firm.

Specifically, we at the New York Fed see the major challenge to be the
enhancement of credit and market risk disclosure. The major trading institutions
headquartered in New York now provide extensive information on actual credit risk
exposure in their annual reports, and we have encouraged these institutions to tackle
potential credit and market risk in the future. In order to achieve the kind of
benchmark standards for disclosure that the Group of Thirty achieved for risk
management, notions of what is proprietary information and what should be in the public
domain will have to change. One thing is already clear: knowing the appetite for taking
risk and the ability to control it at individual firms is essential to understanding the risks
of being a shareholder, a creditor, or a counterparty.

In this regard, I strongly encourage all financial market organizations and other
institutions to approach the issues of accounting and disclosure as users of financial
statements rather than as issuers; what we all need to know about others to be
comfortable should drive the debate, rather than concerns about our own disclosures. It
is self-evident that a full appreciation of risk cannot be developed without sufficient
information. Thus, there is little question in my mind about the urgency of achieving
dramatic progress in the areas of financial accounting and disclosure. A striking aspect
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of the markets over the past year or so has been the recurrent episodes of tremendous
uncertainty as to the exact nature of market forces at work and the size of overhanging
positions. This uncertainty provided a fertile ground for rumors about forced liquidation
of holdings and the financial health of individual firms, and created the potential for
volatile and disorderly markets.

All of us know that there is no greater enemy of the marketplace than a loss of
confidence -- whether in major market participants or in the market mechanism itself.
And while the financial system thus far has withstood the turmoil without great damage,
I think it would be a tremendous mistake for us to ignore the clear message we received
about the inadequacy of information available to market participants.

When even

generally well-regarded firms can be the subject of sudden and intense doubt, we
overlook the implications at our own peril.

I want to emphasize that I agree with the view that this is an international, and
not merely a national, problem. In September, the G-10 central banks, through the Bank
for International Settlements, released a discussion paper regarding disclosure of market
and credit . risk by financial intermediaries.

The observations and recommendations

presented in this paper, known as the Fisher Report, provide a good foundation for
discussion and, ultimately, progress on enhancing public disclosure practices. With
similar efforts being undertaken in the private sector, I think it reasonable to expect
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significant progress in designing a coordinated framework for fuller and more meaningful
disclosure within the year.

Also critical to any financial institution's well-being -- and particularly those with
large trading and derivatives businesses -- are effective internal control systems. This is a
subject that we at the Federal Reserve take very seriously and one that we have recently
been reemphasizing, particularly in our conversations with large banks. Of course,
effective internal controls have always been centrally important to sound banking. This
point becomes entirely clear if we consider for a moment the basic purposes of internal
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to provide reasonable assurance that the bank's and its customers' assets
are safeguarded, that its information is timely and reliable, and that errors
and irregularities are discovered and corrected promptly;


to promote the bank's operational efficiency; and,


to ensure compliance with managerial policies, laws, regulations, and sound
fiduciary principles.


With these purposes in mind, it is clear that the success of any banking
organization depends. in a very real way on the rigor and effectiveness of its internal
controls. And never has this been more true than today. As the activities of commercial
banks have become inc1:easingly diverse and complex, internal controls have become
critically important to the monitoring and management of risk and to the successful
execution of banks' business strategies more generally.

I want to emphasize this point as strongly as I can, as I know that there is a clear
and powerful temptation for management to focus its attention and resources on those
areas and those individuals that generate profits for the institution, especially during
"hot-hand" or streak periods. It is easy to be lulled into focusing on the front office
aspect of your operation, but if something goes wrong in the back office it can quickly
become the most important part of your business. If there was any question about this
reality, Barings has just provided us all with a rather compelling example of what can
happen when internal controls are either insufficient or not enforced. With this in mind,
it is essential that sufficient resources, staff and managerial attention are devoted to the
back office and internal audit functions, as well as to the trading floors and risk
management staffs. And, in an increasingly competitive environment in which banks are
struggling to reduce costs and improve efficiency, special care must be taken to ensure
that such efforts do not jeopardize the rigor and effectiveness of an institution's control
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The other broad issue I want to address is whether changes in the financial system
are altering the potential for systemic risk and weakening traditional protections against
it. Generally, we think of two sources of systemic risk. The first is the failure of a major
market participant and the potential disruption to markets and to other counterparties
that such a failure could cause. As I noted earlier, continued progress in developing risk
management systems at all major market participants, as _well as comprehensive capital
requirements, can help to reduce this risk.

One of the most important safeguards we have against systemic risk is the
appropriate management of liquidity risk -- both funding liquidity and the management
of market access more generally. Clearly, the marketplace over the last 20 years has
been unforgiving for those whose capital and liquidity become strained. But I am
concerned that a long period of ample liquidity may have led market participants to
under-estimate the value of liquidity and the speed with which it can dry up. As trading
volumes have risen, the potential demands for collateral and credit lines to support
payment and settlement mechanisms in stress scenarios have grown. Finally, the recent
months have reminded all of us that market liquidity and the ability to adjust positions
can deteriorate quickly when markets are under stress.

A second potential source of systemic risk is a market dynamic in which a large
initial price move can be deepened and sustained by positive feedback mechanisms, such
as margin calls, program trading, dynamic hedging of options, or steps taken to control
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losses in leveraged positions, all the more when many market participants follow similar
strategies. Last year, for example, rumors and press reports suggested that some
leveraged market participants were being forced to liquidate to meet margin calls. This
reportedly is just what happened to the managers and investors of at least one hedge
fund, with consequences that were felt in the mortgage-backed and Treasury markets.
Ultimately, it is these broader markets that bear the brunt of major market disturbances,
as investors under stress seek liquid marketplaces to adjust their positions.

In this regard, I see a critical need to address the risk of settlement failure in
foreign exchange caused by temporal gaps, known as Herstatt risk. Herstatt risk is
especially troublesome because it goes beyond national borders and affects the financial
system globally. As you may know, Herstatt risk derives its name from an incident in
Germany in 1974 which caused foreign exchange counterparties to Bankhaus Herstatt to
incur substantial losses. Bankhaus Herstatt, having completed its foreign currency
transactions in Europe, was closed down at the end of a German business day, but
before completing its U.S. dollar transactions.

Consequently, counterparties due to

receive dollars were not paid. In the ·days following Herstatt's closure, payments that
normally flowed through the major international payment systems were significantly

In the twenty years since Herstatt, many important changes have been put in
place that have improved the settlement process in foreign exchange transactions, even
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as the foreign exchange markets and the global financial system have undergone
dramatic shifts. But we are still far from eliminating settlement risk in foreign exchange

Finding a more satisfactory solution will require a lot more change -- change in
technologies, change in operations and change in the mindset of some market

An important contribution has come from the work of the New York

Foreign Exchange Committee, which has tried to find a solution to Herstatt risk and
open a dialogue with central bankers and the markets about the issue. Last October, the
Committee released a study on the ways banks have viewed settlement risk traditionally.
The study also included recommendations about how private-sector market participants
can help themselves reduce this risk.

Let me recap three of the most compelling conclusions of the study:

First, and most importantly, the study found that the duration of settlement risk is
much longer than anyone previously thought. The internal procedures of each bank are
the largest source of the duration of settlement risk. The study also showed clearly that
these internal procedures can be altered by the banks themselves in order to reduce their
settlement exposures.
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Second, the study found that netting is a powerful tool for active market makers.
Legally binding netting of payments enables market makers to reduce significantly the
enormous sums that are at risk on any given day.

Third, for most firms, the current finality rules for local payments are an
important factor in determining the extent of the settlement risk. In fact, for firms
operating with close-to-the-current-best industry practices, settlement risk could be
decreased if full intra-day finality were to prevail. When it does, final payments could, if
necessary, be made and reconciled much sooner. This change, in tum, would shorten the
duration of settlement risk.

I found the Committee's approach fundamentally sound and its conclusions quite

They show how much the private sector can do on its own to reduce

foreign exchange settlement exposures by implementing many types of procedures that
are already in existence. The Committee used its findings to develop over a dozen
recommended "Best Practices" to help the industry and individual banks reduce Herstatt
risk. The report's recommendations were put forth in order to motivate individual banks
to act and to promote a dialogue on the issues involved. My intention today is not to
endorse or reject any specific Committee proposal. I do, however, think they are worthy
of discussion and consideration.
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Clearly, resolution of these concerns can be achieved only through a high level of
international cooperation and agreement.

My goal is to .make substantial progress in this

regard during my tenure as chairman of the Payment and Settlement System Committee
established by G-10 central bank governors. I'd like to think that the combination of
private and public attention to this issue could mean the elimination, or at least the
near-elimination, of Herstatt risk. After 20 years, that goal is long overdue. There is
little question that the foundations have been laid, but now must be built upon and
enhanced to reflect the growing complexities of our financial system.

We at the New York Fed have worked closely with industry representatives as
they have developed netting agreements for foreign exchange, and we have followed
closely the efforts of private market participants to develop a foreign exchange clearing
house. The Federal Reserve's decision to open Fedwire for extended hours beginning in
1997 could allow the private sector greater opportunity to develop payments
arrangements that bridge the temporal gap that is the source of Herstatt risk. Besides
foreign exchange, I see the complex web of settlement arrangements for securities in the
major countries, and the related global custody arrangements, as other areas with rich
potential for further strengthening of the payments infrastructure.

Let me conclude by making clear that my message today regarding the critical
importance of effectively managing risk through comprehensive risk management
systems, greater transparency and rigorous internal controls is not intended only for those
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institutions on the cutting edge of financial engineering. It applies to all size institutions,
from the large to the not-so-large, whether they are involved in conventional lending,
trading, trust activities, securities lending or private banking, and to all buyers as well as
sellers of sophisticated products. All too often we have heard institutions say they were
unaware that they were in a "risk"business and therefore had not considered the
implementation of effective risk management systems and controls a priority. This
thinking must change. Risk is inherent in all aspects of financial transactions and it is
imperative that management philosophies, systems and controls evolve and adapt to this

One final observation:

central bankers and the international banking community

share a common stake in the effective functioning of international financial markets.
This stake has never been more important in view of the highly integrated nature of
these markets and the speed with which disturbances in one country's markets can
impact markets in other countries. At the end of the day, while our perspectives of the
risks and challenges may differ, our objectives as supervisors and your objectives as
business executives and bankers are the same, pointing toward maintaining a vibrant and
strong financial system over the long-term. We want to encourage financial market
innovation without compromising the elements which are essential to sound and orderly
markets. Experience has shown repeatedly that prudent risk management and controls
need not hamper creativity.
Federal Reserve Bank of St. Louis

Thank you for the opportunity to address you today.