Developing Supervision and Strengthening Its Capacity
April 10, 2006
William L. Rutledge, Executive Vice President
Remarks at the 19th Annual Conference of the Group of Banking Supervisors from Central and Eastern Europe, Przno, Montenegro

Thank you very much. Let me begin by thanking the organizers for inviting me to speak, and commend them for arranging what should be an informative and timely conference. Certainly, the major topics of discussion over the next two days, disclosure under Pillar 3 and corporate governance, will be key elements that will help shape the supervisory process for all of us going forward.

What I will do this morning is provide some context for your discussions by sharing some general thoughts on the process of strengthening bank supervision—including how that strengthening process should incorporate changing corporate governance expectations and public disclosure practices. Naturally, the views I express will be my own rather than necessarily reflecting those of the Federal Reserve.

They will, however, inevitably reflect my long experience as a bank supervisor at the Federal Reserve Bank of New York, with the special challenges and focus that working in the largest and most sophisticated financial marketplace entails. Nevertheless, there are a number of key themes driving effective bank supervision that are widely applicable regardless of the setting.

The single, most dominant, theme of my remarks is that supervision needs to ensure not only that the financial organizations we supervise are operating in a safe and sound manner in the immediate term, but that the firms are well equipped to continue to do so over time. The focus cannot just be on the “here and now,” but on a longer time horizon as well. This may well differentiate the supervisor’s perspective from that of the general marketplace. While the market must also be focused on the future, not just the present, it clearly places a much heavier premium on immediate financial performance than do we as supervisors. As I will discuss, with more forward-looking disclosures, some of this timing difference in perspective may narrow.

Another theme that will be clear from my remarks—one that ties in closely and underpins the first—is that banking supervision can and should evolve in response to the improving risk management and control architecture of supervised firms. How we do our jobs depends in significant part on how the firms we supervise operate.

A corollary to that theme is that the evolution of bank supervision will necessitate changes in the training, development and expectations for examiners and other supervisory personnel.

Let me turn now to how the supervisory process is evolving and strengthening—both in terms of the supervision of individual firms and in terms of the overall approach to the supervisory process.

For the individual firm, it is logical to begin with an assessment of current condition through an analysis of point–in-time financials. We need to make sure that the banking organization has strength in its current balance sheet, with well-performing loans, a healthy investment portfolio, appropriate reserves, good liquidity on both the asset side and the liability side, and a capital base that is fully sufficient to support its risk taking. As supervisors we need to have examiners who are well-trained and experienced in making all of these assessments of current financials.

With the time horizon I focused on upfront, the supervisors of course cannot stop with that snapshot of current condition as we have to ensure not just the quality of immediate-term financials but also the prospects of the firm maintaining that favorable position over time. Part of the analysis is to have a forward-looking perspective on the financials that we see. How vulnerable is the balance sheet to changing circumstances? Is the loan portfolio heavily concentrated by industry or geographic region in a way that could make it more likely that a limited economic downturn would have major adverse effects? Is the banking organization heavily reliant on cross-border exposures that absent effective hedging could expose the firm to inordinate foreign exchange risk? Training and developing examiners who are able to make these kinds of forward-looking assessments is a material next step in the evolution of the supervisory process.

As I see it though, an even bigger step involves moving from the analysis of financials to the assessment of the quality of the management and managerial processes of the firm. Simply extrapolating the current financial positions of the firm forward in the face of changing economic circumstances does not do justice to a typical bank’s management. A bank with good management obviously will look to adjust its strategies and exposures to changing external developments. Increasingly, in fact, a well- managed firm plans for those possible shifts by systematically exploring potential vulnerabilities through the development of some times very sophisticated scenario analyses, in which management evaluates its business and exposures against the possible stresses that could develop. I will come back to this later in my remarks.

Setting and adjusting the strategic direction, and managing and controlling risks, is first and foremost the responsibility of the banking organization itself. The largest banking organizations, which face the challenge of managing expansive, diverse and complex organizations, have made 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, liquidity risk, operational risk, and legal and reputational risk management. They have staffed and empowered key control functions like internal audit, legal and compliance.

While primary responsibility for a banking organization’s safe and sound operation lies with the firm itself, we as bank supervisors play a key role by critically reviewing bank operations and encouraging the development of the necessary risk management and control processes.

Before getting into more detail as to what this means for the supervision of the individual firm, let me back up a step and say a few words about our broad philosophy of supervisory approach—beginning with the core question of how we should look to achieve the ultimate objectives of supervision.

An obvious key objective is to ensure the long-run strength of the banking industry, but 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.

Accordingly, a key goal of supervision should be 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. The Basel Committee elegantly addressed this basic tension in its core principles for bank supervision, by recognizing 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—including dealing with failures in a way that minimizes disruptive effects.

How do supervisors look to strike this balance? How has our supervisory process evolved to meet the challenges posed by the structural developments and business shifts 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. A checklist approach to undertaking a standardized review of each bank can have value in some circumstances in terms of promoting consistency—and we use a variant of it in supervising small banking organizations. However, if firms have evolved with widely differing business strategies and managerial approaches, that type of supervisory focus will not work.

Similarly, as I indicated in broad terms a moment ago, we now have much more focus on the integrity of the risk management and internal control processes of the individual firm, rather than simply on the validation of its current financials. For example, our focus is much more on the quality and integrity of the processes that generate the credit risks, distribute them and manage those to be retained, rather than on the credits currently on a balance sheet. A critical underpinning of this approach is that the firm has systems with appropriate independence and control to ensure accurate current asset quality assessment.

Another example of our looking to develop a supervisory approach that leverages off of strong control processes is how we focus on the internal audit function. We spend a good deal of time critically evaluating the rigor, comprehensiveness and, of course, independence of the internal audit function. When we determine that the internal audit function is a sound one, we then are much better able to factor its findings into our supervisory plans.

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 the extent to which internal audit can be properly leveraged in our work is an important part of developing the extensive institutional knowledge needed to tailor a supervisory program for each individual firm.

Another factor in developing institutional knowledge is continuity of supervisory perspective. It is important that some of 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 has also led us to go a step further in the supervisory development process by embracing the concept of specialization for our examiners. Supervising the major banking organizations that we do requires the cultivation of specialists with the skills and experience necessary to fully understand the risks being taken through 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 example, the analysis of various capital markets activities. For the major banking organizations in the United States, solely relying on generalist examiners is no longer appropriate.

To emphasize my key theme, 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.

Focus on Resilience

I find that a useful way to capsulize what this longer-term vision should mean both for the supervision of the individual firm and for our supervisory approach more broadly 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 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 Resilience

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, used wisely, 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 (such as various derivatives). 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 also their internal audit, legal and compliance people, and their risk management personnel in the review of possible new products. Once introduced, these products must of course be subject to rigorous ongoing monitoring and control processes.

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, as I suggested earlier, that banks perform rigorous, ongoing stress testing to assess the impact of unanticipated events.

Technological Resilience

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, of 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.

Market Discipline

I promised to say something about how disclosure and market discipline complement formal supervision, and clearly market participants can play an important role. In free and open markets, market participants can use their investment and credit decisions to reward those firms that are performing most effectively. Or more accurately, reward those firms they project will be the most effective performers going forward.

How market participants make those projections is not always easy to determine. Even in a system with sophisticated analysis by rating agencies and other market practitioners that recognize the inherent strength or weaknesses of particular franchises, it seems that the market focuses heavily on short-term matters—for example, often seemingly unduly penalizing modest shortfalls from quarterly earnings estimates. In a finely-tuned market, a great deal of information has already been factored into pricing of debt and equity instruments, and what tends to move the market is anything that comes across as a new development—however unimportant it may ultimately prove to be for the long-run performance of the firm.

If a major uncertainty arises (such as a major legal issue) or if quarter-to-quarter adverse trends seem to be developing, the market can factor a negative judgment in even more strongly—sometimes appropriately, but sometimes exaggerating the import of the trend or development. The tough thing for supervisors and the firm is that negative judgments, even not entirely accurate ones, could become self-fulfilling prophecies.

As I mentioned earlier, these market reactions can be explained to some extent by the difficulty of projecting firms’ performance based on available disclosures. For market discipline to be a truly effective complement to formal supervision, market participants must be armed with accurate and timely information, not just about current balance sheet and income statement elements, but also with information having a longer-term value—such as qualitative and quantitative information on business strategies, risk profiles, and risk appetite.

We have noted some improvements in banks' disclosures in these dimensions over the past several years—some of it in response to new disclosure requirements, some to getting ready for Pillar 3, but much also in response to the pressures of the marketplace. In addition, as firms have developed their economic capital methodologies and become confident enough to rely on them for various internal purposes, we have been seeing more public disclosure of such information. We are looking forward to additional enhancement of banks' disclosures in the coming years.

To exploit the potential of market discipline, Pillar 3 of the Basel II Accord emphasizes transparency and disclosure by banking organizations. Enhanced disclosure of key risk elements and capital by banking organizations should help market participants develop a better-informed view of a bank’s risk profile. In this way, Pillar 3 provides much-needed market encouragement of more prudent risk management, and therefore ties in nicely to the evolving supervisory process that I have just discussed.

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. Working together, the three pillars of the Basel II Accord 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.

This type of approach to regulatory capital, working in concert with the kind of supervisory focus I have been describing, 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.

Thank you very much.

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