SHADOW FINANCIAL REGULATORY COMMITTEE
1999 Annual Report
Administrative Office
c/o Professor George G. Kaufman
Loyola University Chicago
820 N. Michigan Avenue
Chicago, Illinois 60611
312-915-7075
In 1999, the Shadow Financial Regulatory Committee completed its fourteenth year of operation. As in most of its previous years, the Committee met quarterly. It issued six policy statements.
The Committee experienced one change in membership during the year. Jonathan R. Macey, the J. DuPratt White Professor of Law and Director of the John M. Olin Program in Law and Economics at the Cornell Law School, resigned for personal reasons. (Current and past members of the Committee are listed in Appendix A.)
Meetings
As usual, the Committee met for two days--all day on Sundays and on Monday mornings. The 1999 meeting dates were on Sunday-Monday, February 21-22, April 25-26, September 26-27, and December 12-13. All meetings were at the offices of the American Enterprise Institute in Washington, D.C.
The February meeting was a "think-tank" session, devoted primarily to a thorough exploration of the issue of bank regulatory capital standards, particularly in light of the pending proposal by the Basel Committee on Banking Supervision to revise its capital accord. The Committee decided to prepare a long paper or monograph on its recommendations for capital standards, focusing primarily on the use of subordinated debt to increase market discipline on banks and reduce the necessity for regulatory standards and discipline. In addition, the Committee reviewed capital standard in the insurance industry and the implications of the LTCM rescue in 1998. At this meeting, the Committee did not work on policy statements nor hold a press conference. The primary purpose was allot sufficient time for "thinking" about current problems and solutions. The other three meetings were regular meetings devoted to a number of current issues on which the Committee may, after discussion, want to issue policy statements and ending with the release of such statements at a press conference. At its meetings, the Committee followed its usual practice of devoting part of the session to meeting with guests. Guests are usually representatives of policy-makers, regulatory agencies, financial services firms, and trade associations. These meetings are private, closed-door exchanges of ideas on issues of current concern to both parties.
In addition, the first joint meeting of the U.S. Shadow Committee with the new European and Japanese Shadow Regulatory Committees was held on June 13 in New York City. Much of this meeting was devoted to having the members of the Committees know each other better and to review the ongoing and planned activities of each Committee.
Policy Statements
The Committee continues to serve as a major independent public watchdog for monitoring and evaluating events affecting the efficiency and safety of the financial services industry. In 1999, the Committee focused the largest proportion of its time on rethinking bank regulatory capital standards. Other areas of attention included the changing features of the bank modernization legislation that was working its way through Congress during the year and the continued expansion of government sponsored enterprises (GSEs), in particular the Federal Home Loan Banks. Two policy statements (Nos. 154 and 156) dealt with the Committee's views on bank regulatory capital standards and evaluation of the Basel proposals. Statement 159 criticized the expansion of Federal Home Loan Bank lending to small commercial banks on small business and agriculture collateral as is included in the Bank Modernization Act. Statement 157 expressed concern over the very large relative losses associated with the recent delayed resolution of two commercial banks. The Committee will consider the regulatory agency's current practice in examining for fraud and for prompter regulatory actions in its agenda for 2000. Statement 155 encouraged Congress before its enactment of bank modernization to expand bank product powers and not tilt regulatory authority over powers unduly in favor of any one agency. Lastly, Statement 158 enumerated a number of questions that should be answered before Congress adopts federal catastrophe insurance.
The joint meeting of the three Shadow Regulatory Committees in June in New York was devoted entirely to an analysis of the Basel proposal for revisions of bank regulatory capital standards. The representatives of the three Committees agreed that the proposal did not necessarily represent an improvement over the current standards, outlined the reasons why, and discussed the use of a subordinated debt requirement to finance the role of market discipline. The group drafted a joint statement summarizing its discussion and recommendations. Because the three Committees were not fully represented, the joint statement is not an official statement. Nevertheless, it was discussed by the Committee members and released the next day on June 14 at a conference on bank capital at the Council on Foreign Relations in New York City. The joint statement is shown in Appendix D.
Plans for 2000
The Committee will meet quarterly in 2000 on February 20-21, May 7-8, September 24-25, and December 3-4. The major immediate focus of the Committee for the year 2000 will be completion of its proposal on bank regulatory capital standards, emphasizing in particular the need to increase reliance on market discipline through use of subordinated debt as a required component of bank capital. The final draft will be completed be a small drafting committee in January and circulated to all Committee members for last minute minor modifications before a final vote at the February meeting. The report will be published as a monograph by the AEI and will be released publicly at a AEI conference, tentatively scheduled for March 2 at the AEI offices in Washington D.C. In addition, the Committee will devote attention in 2000 to improving and accelerating resolutions by regulators of bank failures, in particular failures due to fraud, and to developments in the insurance and securities areas. With the enactment of broader bank geographic and product powers, the Committee will also monitor and analyze the regulations developed to implement the provisions of legislation.
A second joint meeting of the three Shadow Committees is tentatively scheduled for Tokyo in October 2000. It will again be in conjunction with a conference on banking issues.
Administrative and Financial
The Committee is a tax-exempt 501(c)(3) nonprofit organization. The Committee’s administrative office is at Loyola University Chicago. Beginning in 1999, the Committee has been financially supported entirely by and meets at the American Enterprise Institute, but retains its policy independence.
Appendix A: Statement of Purpose and Membership
The Shadow Financial Regulatory Committee is a group of independent experts on the financial services industry and its regulatory structure.
The purpose of the Committee are: (1) to identify and analyze developing trends and ongoing events that promise to affect the efficiency and safe operation of sectors of the financial services industry, (2) to explore the spectrum of short- and long-term implications of emerging problems and policy changes, (3) to help develop appropriate private, regulatory and legislative responses to such problems, and (4) to assess and respond to proposed and actual public policy initiatives with respect to their impact on the public interest.
The results of the Committee’s deliberations are intended to increase the awareness and sensitivity of members of the financial services industry, public policy markets, the communications media and the general public to the importance and implications of current problems, events and policy initiatives affecting the industry.
Members of the Shadow Financial Regulatory Committee are drawn from academic institutions and private organizations and reflect a wide range of views. The Committee is independent of any of the members’ affiliated institutions or of sponsoring organizations. The recommendations of the Committee are its own. The only common denominators of the members are their public recognition as experts on the industry and their preferences for market solutions to problems and the minimum degree of government regulation consistent with efficiency and safety.
PAST AND PRESENT MEMBERS (1996-1999)
George G. Kaufman, Co-Chair (1986-) Loyola University Chicago
Robert E. Litan, Co-Chair (1996-) Brookings Institution
Richard Aspinwall (1986-) Chase Manhattan Bank (retired)
George J. Benston (1986-) Emory University
Charles Calomiris (1998-) Columbia University
Lawrence Connell (Co-Chair, 1986-98) Attorney at Law
Neil A. Doherty (1997-98) University of Pennsylvania
Franklin Edwards (1986-) Columbia University
Robert A. Eisenbeis (1986-1996) University of North Carolina
Wendy Lee Gramm (1994) University of Texas at Arlington
Scott E. Harrington (1998-) University of South Carolina
John D. Hawke (1986-1995) Arnold & Porter
Richard J. Herring (1990-) University of Pennsylvania
Paul M. Horvitz (1986-) University of Houston
Edward J. Kane (1986-1996) Boston College
Jonathan R. Macey (1998-1999) Cornell Law School
Robert W. Mehle (1986-1993) Attorney at Law
Allan H. Meltzer (1986-1990) Carnegie-Mellon University
Franco Modigliani (1992-98) MIT
Hal S. Scott (1998-) Harvard Law School
Kenneth E. Scott (1986-) Stanford Law School
Peter J. Wallison (1995-) American Enterprise Institute
Appendix B: Policy Statements
Title Date Adopted
1. The Baker Plan and LDC Lending, Feb. 15, 1986
2. Aid to Failing Banks, Feb. 14, 1986
3. Federal Reserve Ruling on Junk Bonds, Feb. 14, 1986
4. Disclosure of Supervisory Actions Examiners' Ratings, June 9, 1986
5. Disclosure by Regulated Financial Institutions, June 9, 1992
6. Proposals for Risk-Related Bank Capital Guidelines, June 9, 1986
7. Capital Forbearance Policy for Agricultural and Energy Banks, June 9, 1986
8. Recapitalizing FSLIC and Zombie S&L's, June 9, 1986
9. Proposal to Facilitate the Interstate Takeover of Failing Depository Institutions, June 9, 1986
10. Federal Home Loan Bank Board (FHLBB) Proposed Rules on Regulatory Capital and Nationwide Lending by Insured Savings and Loan Associations, Aug. 5, 1986
11. Federal Regulation of Activities of State Chartered Financial Institutions, Nov. 17, 1986
12. Conversion of S&Ls from FSLIC to FDIC Insurance Coverage, Nov. 17, 1986
13. Current Bank Holding Company Applications for Increased Securities Activities, Nov. 17, 1986
14. Policies Toward Troubled Depository Institutions, Nov. 17, 1986
15. Proper Financing of Private Party Securities Fully Guaranteed by the Federal Government, Dec. 1, 1986
16. FSLIC Recapitalization, Feb. 9, 1987
17. The Federal Reserve Board's "Source-of-Strength" Policy, May 18, 1987
18. Regulatory Proposals for Risk-Related Capital Standards (Rev.), May 18, 1987
19. Supplementary Statement: Regulatory Proposals for Risk-Related Capital Standards, May 18, 1987
20. Unnecessary Costs of FSLIC Recapitalization Program, Sept. 14, 1987
21. International Debt, Nov. 13, 1987
22. FSLIC Handling of Insolvent Thrift Institutions, Nov. 13, 1987
23. Brady Commissions and Recent Market Events, Nov. 13, 1987
24. The Federal Reserve Board's Request for Comment on the Acquisition of Healthy Thrift Institutions by Bank Holding Companies, Nov. 13, 1987
25. Moratorium on Bank Securities Activities, Feb. 8, 1988
26. Studies of the Stock Market Crash, Feb. 8, 1988
27. Disposal of FDIC Equity Interests in Assisted Banks, Feb. 8, 1988
28. The Southwest Plan for Ailing Thrift Institutions, Feb. 8, 1988
29. Regulatory Proposal for Risk-Related Capital Standards, Feb. 8, 1988
30. Disclosure by Financial Institutions of Financial Assets and Liabilities, Feb. 8, 1988
31. FDIC's New Policy on "Whole Bank" Takeovers, May 16, 1988
32. Proposed FDIC Policy Statements Encouraging Independent Outside Audits of Banks, May 16, 1988
33. Policy Responses to the Stock Market Crash, May 16, 1988
34. FSLIC's Handling of Failed Thrifts, May 16, 1988
35. Need to Make FSLIC and FDIC Assistance Deals Accountable, Sept. 25, 1988
36. The Need to Estimate the True Economic Condition of the FDIC, Dec. 5, 1988
37. Assessing FDIC Premiums Against U.S. Banks' Unsubordinated Debt and Deposits in Foreign Branch Offices, Dec. 5, 1988
38. An Outline of a Program for Deposit Insurance Reform, Dec. 5, 1988
39. The Administration's Plan to Resolve the Thrift Crisis, Feb. 13. 1989
40. Risk-Based Capital and Early Intervention Proposal of Federal Home Loan Bank Board, Feb. 13, 1989
41. An Outline of a Program for Deposit Insurance and Regulatory Reform (Revision of No. 38), Feb. 13, 1989
42. The On-Budget Status of Expenditures to Resolve Thrift Insolvencies, May 15, 1989
43. Financial Institutions Reform, Recovery and Enforcement Act of 1989, May 15 1989
44. The Comptroller of the Currency's Proposal for a Minimum Bank Leverage Ratio, Sept. 18, 1989
45. Federal Reserve Proposal to Modify the Payments System Risk Reduction Programs, Sept. 18, 1989
46. Proposals to Modify Loan Loss Reserves for Third World Debt, Sept. 18, 1989
47. Congressionally-Mandated Accounting for Junk Bond Sales, Sept. 18, 1989
48. The Activities of the Resolution Trust Corporation, Dec. 4, 1989
49. Latin American Debt, Dec. 4, 1989
50. Capital Standards for Member Banks*, Dec. 4, 1989
51. Proposal to Curb Stock Market Volatility, Dec. 4, 1989
52. The FDIC's Proposed Regulation on Purchased Mortgage Servicing Rights, Feb. 26, 1990
53. Subsidized Federal Reserve Assistance, Feb. 26, 1990
54. The Failure of the Treasury's Study of the Federal Deposit Insurance System to Focus on Identifying and Correcting Defects in Government Incentives, Feb. 26, 1990
55. RTC Thrift Resolution Policies, May 7, 1990
56. The Elimination of Restrictions on Bank Securities Activities and Affiliations, May 7, 1990
57. Proposals to Consolidate the SEC and CFTC, May 7, 1990
58. Provision of Seller Financing by RTC in Asset Sales, Sept. 24, 1990
59. Condition of the Bank Insurance Fund, Sept. 24, 1990
60. RTC Property Disposition Policies, Sept. 24, 1990
61. Limiting Taxpayer Loss Exposure in Government-Sponsored Credit Enterprises, Sept. 24, 1990
62. Congressional Intercession with the Financial Regulatory Agencies, Dec. 10, 1990
63. National Branching, Dec. 10, 1990
64. FDIC Ownership of Continental Illinois Stock, Dec. 10, 1990
65. Treasury's Deposit Insurance Reform Recommendations, Feb. 11, 1991
66. Proposals to Inject Additional Funds into the Bank Insurance Fund, Feb. 11, 1991
67. Concerns About the Availability of Bank Credit, Feb. 11, 1991
68. OTS Proposal for Capital Requirement for Interest Rate Risk, Feb. 11, 1991
69. FASB's Proposed Statement of Financial Accounting Standards Concerning "Disclosures About Market Value of Financial Instruments", Feb. 11, 1991
70. Funding of the BIF and Depository Insurance Reform Proposals in H.R. 2094, May 20, 1991
71. Need to Develop a Satisfactory Data Base With Which to Analyze the Economic Condition of Insurance Companies ,May 20, 1991
72. OMB & CBO Statements Calling for More Informative Accounting & Budgeting for Deposit Insurance, Sept. 16, 1991
73. Additional Comments of Deposit Insurance Reform Legislation, Sept. 16, 1991
74. Bank of Credit & Commerce International, Sept. 16, 1991
75. Protecting Taxpayers from Risks of Government Sponsored Enterprises, Sept. 16, 1991
76. FDIC Improvement Act of 1991, Dec. 16, 1991
77. Accounting for Taxpayers' Stake in the FDIC's Bank Insurance Fund, Dec. 16, 1991
78. United States Listing Requirements for Foreign Companies, Dec. 16, 1991
79. Interagency Policy Statement on Commercial Real Estate Loans, Dec. 16, 1991
80. FDIC's Program for "Hospitalizing Sick Banks", Feb. 17, 1992
81. Using Risk-Related Capital Standards to Promote Housing, Feb. 17, 1992
82. Need to Regulate Interest Rate Risk, Feb. 17, 1992
83. The FDIC's Proposed Schedule of Risk-Sensitive Premiums, June 1, 1992
84. Brokered Deposits and Capital Requirements, June 1, 1992
85. The TDPOB's Proposed Early Resolution/Assisted Merger Program, June 1, 1992
86. SEC Listing Requirements for Foreign Securities, June 1, 1992
87. Rule Proposed by Bank Regulators to Control Interest Rate Risk, Sept. 14, 1992
88. Proposed Rule on Interbank Exposure, Sept. 14, 1992
89. Standards for Safety and Soundness, Sept. 14, 1992
90. An Open Letter to President Clinton, Dec. 14,1992
91. Proposed Changes in the FDIC's Risk-Related Premium System, March 1, 1993
92. FDIC Action on Critically Undercapitalized Banks, March 1, 1993
93. Taxpayer Risks in the Pension Benefit Guarantee System, March 1, 1993
94. The Policy of Authorizing "Minimal Documentation" Loans, May 24, 1993
95. "Fair Value" Reporting for Insured Depository Institutions Required Under FDICIA, May 24, 1993
96. Modifying Risk-Based Capital Standards to Account for Interest-Rate Risk, May 24, 1993
97. FDIC Pilot Reinsurance Program, May 24, 1993
98. The New Depositor Preference Legislation, Sept. 20, 1993
99. Proposals to Permit Banks to Branch on an Interstate Basis, Sept. 20, 1993
100. The Proposed Federal Banking Commission, Dec. 13, 1993
101. Safety and Soundness Standards, Dec. 13, 1993
102. Deterioration in the Financial Condition of the Pension Benefit Guarantee Corporation, Dec. 13, 1993
103. Principles of Regulatory Restructuring, Feb. 14, 1994
104. Mutual to Stock Conversions of Thrift Institutions, Feb. 14, 1994
105. Proposed Revisions to Community Reinvestment Regulations, Feb. 14, 1994
106. Proposed Lengthening of Examination Schedules and Required Independent
Audits for Thrift Institutions, May 23, 1994
107. Federal Displacement of State Laws: Fair Credit Reporting and Interstate Branching, May 23, 1994
108. Proposed Increases in FHA Insurance Limits, May 23, 1994
109. Financial Accounting Standard 115, May 23, 1994
110. Final Rules on Incorporating Concentrations of Credit Risks Into Risk-Based Capital Standards, Sept. 26, 1994
111. Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, Sept. 26, 1994
112. Regulatory Agency Measurement of Bank Capital for Prompt Corrective Action, Dec. 12, 1994
113. Proposed Community Reinvestment Act Regulations, Dec. 12, 1994
114. FDIC Insurance Assessments, Dec. 12, 1994
115. Repeal of the Bank Holding Company Act and Restrictions on Product Diversification for Banking Organizations, Dec. 12, 1994
116. Open Letter on Financial Reform to the Senate and House Banking Committees, Feb. 13, 1995
117. Emergency Assistance for Mexico, Feb. 13, 1995
118. Principles of Bank Reform: Guidelines for Assessing Pending Legislative Proposals, May 22, 1995
119. Wholesale Banking Proposal Under H.R. 1062, May 22, 1995
120. The Leach Bill, May 22, 1995
121. Proposed Amendments to Part 5 of the Regulations of the Office of the
Comptroller of the Currency, May 22, 1995
122. Federal Reserve Proposal for Pricing Daylight Overdrafts, May 22, 1995
123. Alternatives to Recapitalizing the Savings Association Insurance Fund, May 22, 1995
124. The Banking Agencies' Proposed Interest Rate Risk Capital Standards, September 18, 1995
125. Alternatives to Recapitalizing the Savings Association Insurance Fund and
Defeasing the FICO Bonds, September 18, 1995
126. Values of Bank Capital Tripwires for Prompt Corrective Action and Least
Cost Resolution, December 11, 1995
127. Reduction in Premiums for BIF-Insured Institutions, December 11, 1995
128. Bank Merger Law and Policy, December 11, 1995
129. Ownership of Stock by Bank Directors, December 11, 1995
130. Expansion of Bank Powers by Regulation, February 12, 1996
131. Extending the Credit Reform Act to GSEs, February 12, 1996
132. Disclosure of Examination Reports and Ratings, May 6, 1996
133. Proposed Legislation on Enterprise Resource Banks (The "Baker Bill," H.R. 3167), May 6, 1996
134. A Proposal for Privatization of the Federal Home Loan Bank System, May 6, 1996
135. An Open Letter to President Clinton on Financial Reform, December 9, 1996
136. Recent Fed and OCC Rulings on Permissible Bank Activities, December 9, 1996
137. Bank Activities and the Extension of Bank Subsidies, May 5, 1997
138. Restrictions on Banking-Commerce Affiliations, May 5, 1997
139. H.R. 10 ("Leach Bill") and the Commerce Subcommittee Draft,. September 22, 1997
140. Mortgage Lending by Federal Home Loan Banks, September 22, 1997
141. Strategic Plans of Federal Financial Institution Regulatory Agencies, December 7, 1997
142. Congress and Financial Reform, December 7, 1997
143. Sweep Accounts and the Prohibition on Paying Interest on Reserve, December 7, 1997 Balances and Demand Deposits.
144. Expanded Powers for Federal Home Loan Banks, May 4, 1998
145. International Monetary Fund Assistance and International Crises, May 4, 1998
146. The Credit Union Membership Access Act, H.R. 1151, May 4, 1998
147. Mergers and Acquisitions in the Banking Industry, May 4, 1998
148. Principles for Reforming the "Global Financial Architecture", September 28, 1998
149. The Use of Private Credit Ratings for Determining Capital Requirments, September 28, 1998 for Securitizations
150. The Senate vs. Version of H.R. 10, September 28, 1998
151. The Issues Posed by the Near-Collapse of Long-Term Capital Management, September 28, 1998
152. The G-7’s New Precautionary Credit Line Facility for the IMF and Its Use in Brazil, December 7, 1998
153. The Federal Reserve Board and Prudential Supervision, December 7, 1998
154. Revising the Basle Capital Standards, April 26, 1999
155. The Latest Round of Bills on Financial modernization, April 26, 1999
156. The Basel Committee’s New Capital Adequacy Framework, September 27, 1999
157. The Failures of BestBank and First National Bank of Keystone, September 27, 1999
158. Proposed Federal Catastrophe Reinsurance, December 13, 1999
159. Federal Home Loan Banks, December 13, 1999
Appendix C: 1999 Policy Statements
Nos. 154-159
Statement No. 154, Statement No. 155, Statement No. 156, Statement No. 157, Statement No. 158, Statement No. 159
Appendix D: JOINT UNOFFICIAL Statement of European, Japanese, and United States SHADOW FINANCIAL REGULATORY Committees
June 13, 1999
New York, NY
Improving the Basle Committee’s New Capital Adequacy Framework
Joint Statement by a sub-group of the Shadow Financial Regulatory Committees of
Europe, Japan, and the U.S.
New York, June 14, 1999
The Basle Committee’s proposed reforms of international bank capital standards suggest an increasing reliance on commercial credit ratings and internal bank risk ratings. These reforms, although laudable in intent, do not adequately address fundamental weaknesses in the existing system for setting prudential capital standards. We offer criticisms of the proposed reforms and suggest a new direction for improving minimal regulatory standards for capital. Among other things, we recommend supplementing the existing framework with a minimum subordinated debt requirement as a means to bring market discipline to bear on bank risk and capital management.
On June 3, 1999 the Basle Committee on Banking Supervision issued a proposal for a new capital adequacy framework for internationally active banks. The 1999 proposal is particularly intended to replace the 1988 Basle Committee Accord on credit risk.
The reason for this overhaul is that the 1988 Accord has some fundamental drawbacks. As is phrased by the Basle Committee itself: "The current risk weighting of assets results, at best, in a crude measure of economic risk, primarily because degrees of credit risk exposure are not sufficiently calibrated as to adequately differentiate between borrowers’ differing default risks. Another related and increasing problem with the existing Accord is the ability of banks to arbitrage their regulatory capital requirement and exploit differences between true economic risk and risk measured under the Accord. Regulatory capital arbitrage can occur in several ways, for example, through some forms of securitization, and can lead to a shift in banks’ portfolio concentrations to lower quality assets".
In its June 1999 paper, the Basle Committee proposes replacing the existing system of credit risk weightings by a system that would use commercial agencies’ credit assessments for determining risk weights. The Committee is also considering allowing ‘sophisticated banks’ to use their internal ratings of loans as a basis for setting regulatory capital charges. Moreover, as a potential future successor for the internal ratings, the Committee intends to investigate whether sophisticated banks could be allowed to use credit-risk portfolio models for calculating regulatory capital requirements. With respect to the definition of regulatory capital and the minimum required capital ratio, the Committee maintains at this stage the existing rules of the 1988 Accord.
An analysis of the existing Basle standards, and the proposed reforms, can be usefully divided into four parts:
The measurement of bank portfolio risk;
The measurement of bank capital;
The establishment of minimal standards for capital relative to risk; and
The role of market discipline in influencing bank capital and risk choices.
Measuring Bank Portfolio Risk
With respect to the measurement of risk, in constructing the new risk weights, the Basle Committee’s proposal places new reliance on the assessments of commercial agencies’ credit ratings and internal bank risk ratings. The goal is laudable - to move away from arbitrary, categorical measures of risk, but in practice neither commercial rating agencies, nor internal risk ratings are reliable regulatory tools.
While the use of commercial credit ratings to measure loan risk is a move toward rationalization of risk weights, it still keeps in place the crude additive approach to measuring the risk of a portfolio. Futhermore, the risk weights are not derived from the private ratings in a consistent manner; entities with similar default risks and ratings are given different risk weights. Moreover, increasing the reliance on ratings for setting prudential standards in bank regulation creates an incentive for ratings agencies to serve the interest of the borrowers being rated, and thus subverts the original purpose credit ratings were intended to serve.
The move toward greater reliance on self-measurement of risk also could be an improvement, but only if credible penalties could be levied on banks if they consistently underestimate their risk. The problem here is the credibility of such penalties because it may be difficult (politically and economically) to penalize banks when they suffer losses and thereby become undercapitalized, particularly as long as information about bank compliance remains solely in the hands of the regulators. When information about internal risk management is not made public, and when the determination of the reasonableness of bank risk estimates remains in the hands of bank regulators, the possibility of regulatory forbearance must be considered a distinct possibility.
Measuring Bank Capital
Although the Basle Committee does not propose changes in its definition of capital, we believe some significant improvements are possible. Improving bank accounting practices by moving to a market-based method of accounting for assets and liabilities would provide a measure of capital that more meaningfully reflects banks’ economic condition.
We also believe that the definition of capital should be revised. The current standards discriminate against the use of subordinated debt in satisfying capital requirements. Subordinated debt can provide a credible buffer against losses to depositors (or deposit insurers) if it is not protected from the risk of loss, and in this sense it can serve as an adequate substitute for equity capital. Indeed, as we argue below, it is desirable to mandate a minimum proportion of credibly unprotected subordinated debt as part of a bank’s capital adequacy requirement.
Establishing Minimal Standards for Risk-Based Capital
The Basle Committee does not propose any changes in the ratio of capital to risk-adjusted assets, but again we believe changes are warranted. One question to consider is whether the current level of capital relative to risk-weighted assets is appropriate. Historical evidence on bank capital structure, as well as evidence on how banks and other financial institutions today choose capital ratios when they are subject to market discipline, suggests that minimum capital ratios should be higher than those currently in place.
Another question is whether it might be desirable for a simple leverage ratio to replace a risk-based capital ratio as the regulatory minimum. Insofar as both approaches mismeasure asset risk, both create potential distortions. Distortions in bank decision making occur when regulatory constraints determine a bank’s choice of capital (that is, when bank capital ratios reflect regulatory requirements rather than market requirements). Inaccurate risk weights offer opportunities to arbitrage risk standards. It is not obvious whether it is more distortionary to set uniform (and, therefore, necessarily inaccurate) risk weights (as in a simple leverage requirement) or to set varying (but also inaccurate) risk weights. To the extent that risk varies across loans, and to the extent that risk weights capture much of that variation, it may be desirable to maintain a capital standard based on regulatory risk weights. While it is hard to judge which approach is better in general, we believe that either a simple leverage requirement, or the Basle Committee’s proposed changes in the calculation of risk weights would be superior to the current system.
Enhancing and Harnessing Market Discipline
Given the inadequacies of the current standards, and the Basle Committee’s proposed reforms, for ensuring accurate measurement of risk and capital, and an adequate amount of capital, we propose supplementing the Basle Committee’s capital standards with an additional subordinated debt requirement. This requirement would ensure a continuing market assessment of the extent of bank portfolio risk and capital, and the use of market assessments to enforce effective regulatory capital standards. The Basle Committee’s reform proposal also recognizes the desirability of enhancing market discipline to influence bank risk and capital management, but does little to enhance market discipline.
The uninsured debt requirement could act as an important mechanism for enhancing market discipline, both to banks as well as regulators. If a bank suffered losses of asset value and/or faced increases in asset risk, uninsured debt holders would discipline the bank by raising yield spreads or inducing the bank to act in credible ways to reduce asset risk or raise equity. Uninsured debt holders have powerful incentives to act as risk disciplinarians of banks. Contrary to equity holders, they hold a fixed income claim and are not entitled to share in upside gains. Increased asset risk may benefit shareholders of insured banks when capital is low or negative, but more asset risk always hurts uninsured debt holders because high risk increases the probability of their not being fully repaid.
Informed market opinion, such as those revealed in yield spreads on credibly uninsured debt, could provide a reliable measure of overall bank risk on which to base regulatory guidelines. Yield spreads on uninsured debt could provide a basis for determining deposit insurance premia, where such deposit insurance systems exist. Also, yield spreads could serve as triggers for regulatory interventions to restrict bank risk taking. To avoid regulatory forbearance those interventions should be based on clearly established principles and rules, commonly referred to as ‘structured early intervention and restructuring’ or ‘prompt corrective action’.
