Bank Supervision and Financial Center Development

September 1, 2005

William L. Rutledge, Executive Vice President

Remarks at the People's Bank of China, Beijing

Thank you very much. It is a pleasure to be here today and I thank the People’s Bank for inviting me. This afternoon, I will share some general thoughts on what needs to be in place for a city or region to operate as a financial center, and on how the Federal Reserve’s bank supervisory process has contributed to the enduring role of New York City as such a leading global center. The views I express will of course be my own rather than necessarily reflecting those of the Federal Reserve.

I will begin with some thoughts on various attributes that are common to most internationally recognized financial centers. These attributes should not be considered an exhaustive list. I would also emphasize that satisfying these elements would not represent a definitive formula for success. Clearly, there is no defined list of ingredients that I or anyone else can spell out, whose satisfaction would automatically result in a city or region becoming a globally recognized center for finance. Rather, my comments represent a set of the kinds of conditions commonly found in the rich economic histories of centers such as London and New York.

What are some of these conditions? A prime consideration, of course, is that a city or region operates within a national political and financial framework that is stable, healthy and dynamic. Building, and sustaining, this framework requires a strong foundation that includes, for example, the presence of a well-trained workforce, a respected and independent legal system, a reliable transportation network, and a range of corollary services available to support day-to-day business transactions. Another key factor is that a city or region has a financial sector and technological infrastructure that are widely recognized as being strong and resilient. A financial structure’s resiliency depends not just on its capacity to withstand shocks in the short term, but its ability to serve as a foundation for longer-term stability. Ultimately, of course, an unavoidable fact of market economics is that market participants play the key role in determining which cities or regions are financial centers. Without the explicit and implicit support of market participants, a financial center simply cannot thrive.

For the United States, and for New York City in particular, the Federal Reserve plays a major role in furthering some of these considerations. Our efforts in support of macroeconomic stability are of course critical. Credible and transparent monetary policy fosters and sustains sound macroeconomic conditions, characterized by low inflation and reasonable GDP growth. These are important preconditions for a well-functioning financial sector.

As a bank supervisor though, my comments today will not be on those factors, but rather will be first, on how a healthy banking system continues to be a key driver of the strength of the broader financial sector, and second, on how the Federal Reserve’s efforts have contributed to the resilience of the banking sector. The need for a bank supervisory focus on longer-term stability and resilience of the banking sector, in support of the development and maintenance of a financial center, will be a major theme of my remarks today.

The Critical Role of Banks in the Financial System
The reasons why well-functioning banks have historically been critical to the development of a healthy and dynamic financial system are easy to enumerate.

First, banks have historically been the principal repository for the public’s liquid funds. Banks provide transaction accounts, assuming liabilities payable on demand at par that are readily available for transfer to third parties. Consumers or business people want to be able to place money in such accounts without fear of loss of principal or liquidity; the accessibility and mobility of these funds is essential to the stability and efficiency of the financial system. This function takes on special significance in periods of financial stress, since the ability to quickly move bank balances to third parties provides certainty in making and receiving payments, which is essential to ensure that financial disruptions do not spread.

Second, banks have traditionally served as the principal financial intermediaries between savers and borrowers. Banks use their deposits to make loans and investments, thereby serving to funnel savings to borrowers who put these funds to productive use. This role is particularly prominent where capital market alternatives to banking sector products are not readily available to the public. But even in systems where other financial sector alternatives exist, or where the role of banks as direct intermediary has declined, banks have generally continued to play significant indirect roles in permitting financial markets to function smoothly.

Third, monetary policy has generally relied on banks as the principal conduit between the central bank and the economy. Central bank reserve requirements place the banking system in a unique position as a channel through which the central bank affects financial market conditions. Simply put, a robust and adaptable banking system limits the friction and delay in transmitting the effects of monetary policy to the whole financial system and ultimately to the economy at large.

Fourth, and finally, commercial banks have been critical to the functioning of payments systems. A reliable and efficient payments system is a necessary component of an advanced industrial economy. In the United States, we have seen the payments system grow rapidly in scale, and banks continue to be crucial in ensuring the system works smoothly. Most large dollar payments continue to run directly through the banking system, and most retail payments at least indirectly involve the banking system as well.

These key roles for the banking system overall continue to be critical, despite numerous structural changes in our financial markets. As I will discuss, these structural changes have implications for the Federal Reserve, as both a central bank and a bank supervisor, but they do not fundamentally change historical realities.

Two of the most striking market developments in the United States in the past 20 years are the increasingly important role of nonbank financial institutions and the ongoing consolidation of the banking sector.

The growing influence of nonbank financial firms has been an important, and much discussed, development. The share of assets held by these institutions now far exceeds the share held by banks. Part of this shift has gone toward traditional entities such as mutual funds, which have attracted a greater share of total financial system assets given the general strength of the stock and bond markets. At the same time, the range of financial market participants has expanded markedly with nontraditional entities such as hedge funds growing in importance and market impact.

Still, while the overall share of public assets held by banks is declining, this should not be interpreted to mean that banking organizations are no longer extremely important. The largest banking organizations have major nonbank affiliates in addition to their banks. They also remain at the heart of numerous major financial markets, such as the rapidly growing structured derivative and securitization markets, where importance is not well measured by asset size.

In addition, banks remain crucial to the credit origination process, and by providing lines of credit and assuming other off-balance-sheet exposures, banks drive the operation of financial markets and lower the cost of market-based finance for many market participants. Having a strong banking sector is critical to having a strong financial sector—a point that is equally true in less developed economies.

The other structural development I mentioned—the rapid pace of market consolidation in the U.S. banking industry—has led to changes in how we go about ensuring that the banking sector stays strong. As banks have consolidated in order to adapt to market deregulation, technological innovation and competitive pressures, banking institutions of enormous size, complexity, and scope of activities have emerged. We now have several organizations having a trillion dollars in assets, and the top five U.S. bank holding companies now hold about 45 percent of U.S. banking assets—almost twice the share they held 20 years ago.

What are the implications of this dramatic growth? Importantly, consolidation should make these very large banking institutions less susceptible to specific shocks and better prepared to absorb larger shocks than was true in the past. Their ability to generate earnings, their level of available capital, their geographic reach, and the sheer diversity of their operations collectively signal that the core of the U.S. banking system is in all probability more stable in the face of a broader range and greater magnitude of possible adverse events than ever before.

At the same time, however, the increased size and scope of these institutions mean their ability to function is that much more important for the stability of the overall banking sector. Simply put, the failure of one of them could have a broader systemic impact than in the past and could be considerably more difficult to resolve.

Accordingly, it is critically important that the risk management efforts of the firms, our supervisory policies, and our regulatory capital requirements should each support the safe and sound operations of the banking sector. I will discuss how each of these elements should work together in assuring a resilient banking sector that can be the backbone of a dynamic financial center.

Ensuring the Resilience of the Banking Industry
While the bulk of my remarks will deal with the supervisory process, let me turn first to how the increasingly complex nature of banking activities at the largest firms has profoundly influenced how these organizations manage themselves. The safe and sound execution of banks’ strategic objectives depends, now perhaps more than ever, on solid risk management processes and effective internal controls. For the largest banking organizations, the challenge of managing expansive, diverse and complex organizations has required major shifts in how they look to maximize risk-adjusted profits and minimize associated risks.

To accomplish these objectives, well-run organizations have devoted a great deal of attention to establishing strong corporate governance systems—systems with effective and independent boards of directors, strong senior management direction and oversight, and sophisticated systems of checks and balances to ensure that risks are understood and controlled. These firms have established extensive risk management systems, bringing together expertise in each of credit risk, market risk, operational risk, and legal and reputational risk management. They have staffed and empowered key control functions like internal audit, legal and compliance. In a very real sense, middle office and back office operations have become critical components of banks’ businesses.

While primary responsibility for a banking organization’s safe and sound operation lies with the firm itself, bank supervisors play a key role by critically reviewing bank operations and encouraging the development of effective risk management and controls, not just in the immediate term but over time. In thinking about our role, it is useful to consider what the ultimate objective of supervision should be: if the goal is to ensure the strength of the banking industry, does that lead us to inevitably conclude that supervisors should aim to ensure that banks do not fail? We do not believe that. Not only is that ambitious objective a nearly impossible task, but it is not an optimal approach to supervision. In a market economy, failures and losses are part of risk-taking. And risk-taking is a necessary feature of a dynamic market-based economy.

Rather, a key objective of supervision is to encourage innovation and calculated risk-taking by banks, while ensuring that these processes are managed in such a way as to promote safety and soundness. That is the fundamental balancing act of bank supervision. Elegantly addressing this basic tension, the Basel Committee, in establishing its core principles for bank supervision, recognized a distinct trade-off between supervisory protection and the cost of financial intermediation. A supervisory process that is too intrusive can hinder optimal asset allocation and stifle business innovation. Supervisors should of course always be adequately prepared to deal with problem situations as they arise.

If the objective of supervision is to strike this balance, how has our supervisory process evolved to meet the challenges posed by the structural developments in the banking sector? Supervisory techniques that may have been adequate 20 years ago are clearly unable to meet the supervisory objectives for today’s larger, more complex banks.

Broadly speaking, we have made our process more dynamic in its orientation—developing more flexible supervisory approaches that are geared specifically to the risks of each particular bank; gone is the checklist approach to undertaking a standardized review of each bank. There is also now much more focus on the integrity of the risk management and internal control processes than on the validation of the current financial statements of the firm. For example, our focus is no longer so heavily on evaluating the quality of the loans on a bank’s books at a point in time; rather the focus is on the quality and integrity of the processes that generate those credit risks and manage them over time. Another example is our focusing on the quality of the audit process as a critical element in the overall internal control of the firm. Thus, we spend a good deal of time critically evaluating the rigor and comprehensiveness of the internal audit function. When we determine that the internal audit function is a sound one, we then are able to leverage off of what it does in structuring our own supervisory approaches.

Assessment of the internal audit function is therefore a key piece of the examinations planning process as we design exam approaches suited to the risks specific to each banking organization. Understanding a firm’s individual risk profile requires extensive institutional knowledge, and so it is important that the same people supervise a given organization for a reasonable period of time—getting to know and evaluate its management, its business direction, and, most importantly, its risk profile. For the largest banks we have dedicated teams that follow the bank year round.

The increasingly sophisticated nature of banking also requires the cultivation of specialists with the skills and experience necessary to fully understand the implications of a bank’s complex business lines. Armed with deep and sophisticated understanding, a specialist can ask the tough questions necessary to determine where problems are most likely to surface. We use specialists in a variety of areas, including for various capital markets activities. For the major banking organizations in the United States, solely relying on generalist examiners is no longer appropriate.

This supervisory focus on banks’ risk management mechanisms and internal controls allows us to assess not just a bank’s strength today, but the bank’s ability to function well over time. When the process is working well, the supervisor’s time horizon should not be quarter to quarter or even year to year. Rather the supervisor should be focused on promoting stability of the banking and financial sector over a broader sweep of time. I find that a useful way to describe what this longer term vision should entail is to focus on the concept of resiliency—resiliency in the very broad sense of how well major firms and the system overall can deal with changing circumstances and external shocks over time.

Let me now turn to how we are seeking to promote banking organization resiliency in various forms—specifically, strategic resilience and innovation; ongoing business resiliency; and technological resiliency.

Strategic Resiliency
A primary focus of supervisors should be the strategic resiliency of banking organizations. To ensure a dynamic banking system, we need banking organizations to have the strategic flexibility to broadly change their businesses to take advantage of competitive opportunities that arise.

A bank’s ability to adjust its strategic objectives over time is critical to maintaining the long-term dynamism of the banking system. In the U.S. context, the growth of market-based finance drove commercial banks to press for legal and regulatory changes to allow them to significantly diversify their activities. With those changes, banking organizations now offer a variety of investment and insurance products, and have added investment banking and merchant banking functions to their array of services.

Less dramatic shifts occur on a much more continuous basis—offering many opportunities for banks to introduce innovative products to satisfy market needs. The growth of derivatives is an obvious example. These instruments permit market participants to manage and price risks more effectively—a positive development for the broader financial market. Meeting their expanding needs to hedge or diversify their risks has also contributed to the bottom line profitability of many banks.

However, while encouraging banks to pursue strategic opportunities as they arise, supervisors must ensure that banks fully understand the risks that they are taking and are able to measure and manage those risks appropriately. A key supervisory focus in this regard is on assessing the rigor of the firm’s process for new product approval, particularly for the most complex products. New product review should be undertaken by a range of personnel with sufficient experience, training and stature to evaluate the full set of risks and potential control problems. Accordingly, banks should involve not just their business people, but their internal audit, legal and compliance, and risk management people in their review of possible new products.

Business Resilience
In addition to promoting this kind of strategic resilience, supervisors should also seek to ensure a bank’s resiliency on an ongoing basis against various financial, economic and other external shocks. Unanticipated interest rate or exchange rate movements are good examples of such potential shocks. We have found that risk models do not always take into account as fully as they should market liquidity, or the ability to trade out of positions in the event of a sudden shock. A major disturbance, or a combination of several concurrent disruptive events, can seriously affect many banks’ exposures simultaneously and thus potentially lead to larger systemic effects.

The potential for adverse shocks poses significant challenges for risk measurement. Widely-used measures of risk, such as value-at-risk, are limited in their effectiveness because they tend to reflect potential for loss under generally normal market conditions over short-term horizons. These models typically do not fully take into account very rare adverse events, in which conditions can rapidly change in a very short period of time. As we learned all too well with the problems of Long-Term Capital Management following the Russian debt default in 1998, there are many ways in which financial disruption in one part of the world can affect major financial centers worldwide.

To ensure a bank’s resiliency against these and other shocks, we are looking to ensure that banks perform rigorous, ongoing stress testing to assess the impact of unanticipated events.

Technological Resiliency
Given the importance of technology to bank operations, both internally and between firms, a third supervisory focus is on the long-term technological resiliency of a firm’s operations. Banks are not only subject to risk related to credit and market exposures, but also to operational problems which inevitably occur from time to time. As supervisors, we have emphasized for some time that individual banking organizations must invest in back-up arrangements to ensure that processing can continue in the event of a technological disruption. The ability of a firm to resume operations quickly and accurately when its primary processing facilities face disruption is critical not only for the firm itself but, in many cases, for the overall financial system.

Technology is, or course, vital to the smooth functioning of the payments system. Payments activity today is undertaken by a diminishing number of global financial institutions. Accordingly, there are now fewer participants accounting for a larger share of the expanding and increasingly global payments business. It is important that those banks ensure a level of technological resilience that is commensurate with their importance to the financial system. We have therefore been requiring for various core clearing activities that organizations establish out-of-region back-up arrangements to recognize the kinds of risks that September 11, 2001, so vividly demonstrated.

Before closing, let me bring in one final element to the process of ensuring the strength of banking institutions—that is, ensuring the strength of the capital supporting each major bank’s operations. The Basel II Accord, with its emphasis on strong risk management practices, should complement the approach to bank supervision I have described and be an integral part of our supervisory process going forward. The implementation of Basel II should result in more resources being applied to improving bank risk management practices. This should result in banks’ pricing becoming more reflective of risk, and in better capital allocation across firms, borrowers and industries. In fact, Basel II has already led financial institutions to deepen and accelerate their efforts to improve the evaluation, quantification and disclosure of risk.

One aspect of the Accord, Pillar II, is especially important in light of the supervisory process I have been discussing. A rules-based approach to capital requirements will almost inevitably lag the changing risk profiles of complex banking organizations, particularly as they take advantage of newly available business opportunities. Through Pillar II, banks and their supervisors will be required to do firm-specific reviews of capital needs.

I think it is useful to think of risk, capital, and supervision as being conceptually three points of a triangle. One leg of that triangle links risk and supervision: the nature and extent of the risk taken on by a bank should be reflected in the risk-focused supervisory strategy that should be followed. A second leg of the triangle links risk to capital through a more risk-sensitive approach to capital regulation. The third, and final, leg of the triangle is the link between capital and supervision—a link best expressed by supervisors’ evaluating how well firms assess their own capital and engage in stress testing.

Understanding and leveraging the relationships expressed by this triangle should help to make supervision more responsive to change and more tailored to each bank’s individual profile. A more flexible and forward-looking approach to regulatory capital and supervision will encourage innovation and promote the continuous development of better risk management tools. For all of us, that holds the promise of a more stable banking system, with the potential for reductions in systemic risk, and stronger assurance of continued and vigorous circulation of credit over time.

The Federal Reserve’s efforts as a supervisor have I think contributed to the strength and resiliency of our banking sector, which in turn promotes stability for the broader financial system and supports New York City’s continuing to be one of the true centers of the global financial system. In similar fashion, a strong and resilient banking sector, supported by a forward-looking supervisory focus, is a necessary element for other existing or prospective financial centers.

Thank you very much.

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