Speech

For Release on Delivery 10:00 A.M. EDT Statement by Paul A. Volcker Chairman, Board of Governors of the Federal Reserve System before the Subcommittee on General Oversight and Investigations of the Committee on Banking, Finance and Urban Affairs House of Representatives April 30, 1987 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis I appreciate the opportunity to appear before this Committee to discuss the joint proposal of the U.S. federal banking agencies and the Bank of England for the establishment of a risk-based capital framework. As you may be aware, the U.S./U.K. proposal, as well as the Federal Reserve's implementing guidelines, are still out for public comment. Thus, the final shape of the risk-based framework is subject to revision in light of the public comments and further consideration of the important issues involved. In developing this proposal, the U.S. and U.K. banking authorities faced a number of difficult supervisory and competitive questions, as well numerous technical questions. They have been at least tentatively resolved in a process of discussion and reasonable compromise. The net result promises, I believe, a framework for significantly strengthening our current regulatory procedures for assessing capital adequacy. In addition, the U.S./U.K. proposal constitutes an important concrete step in the direction of greater harmonization and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis convergence of supervisory policies among countries with major banking institutions• Concern about capital adequacy stems largely from capital's role as a buffer to absorb unexpected losses that a banking organization's current earnings cannot cover. In so doing, capital reduces the likelihood of bank failures and thereby protects depositors, other bank creditors, and the deposit insurance funds. The protection bank capital provides also serves to maintain public confidence in the banking system as a whole. Capital Trends and Federal Reserve Guidelines Program Throughout most of the 1970s and early 1980s, bank capital ratios, particularly those of the larger banking organizations, declined significantly. During this period, banks were forced to operate in a difficult environment characterized by accelerating inflation, high and volatile interest rates, and a rising incidence of corporate bankruptcies. The deregulation of interest ceilings on deposits and the growing competition in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 3 - market for financial services added to these pressures. At the same time overseas expansion and competition with foreign banks resulted in significant growth in assets for the large inter- national institutions; and in the process spreads between the cost of money and loans tended to narrow. As a result, the declining capital ratios of some of the larger organizations became of growing concern to regulators. Those concerns were reinforced by evidence that risks in the banking system, both domestically and internationally, had clearly increased. Against that background, the federal bank regulatory agencies first adopted formal capital guidelines in 1981. These guidelines, which set minimum capital requirements based on the ratios of "primary" and "total" capital to total assets, have been modified and strengthened on several occasions since their adoption. At present, all banks and bank holding companies are required to meet a minimum primary capital to assets requirement of 5.5 percent and a minimum total capital to assets requirement Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 4 - of 6.0 percent. Since these requirements are minimums, most banking organizations are expected to, and in fact do, operate above the supervisory standards. When we implemented the more formal capital requirements, we stated that, in addition to arresting the decline in capital ratios, we intended to modify our regulatory and supervisory policies to encourage banking organizations to strengthen their capital positions over time. The present requirements are higher than the ratios established in 1981. The Federal Reserve expects banking institutions seeking to undertake significant expansion to maintain particularly strong capital positions, well above the minimum supervisory standards. In addition, we have encouraged banks with poor earnings or other financial problems to conserve their capital by adopting more conservative dividend policies. Primary capital consists of stockholders1 equity, perpetual preferred stock, loan loss reserves and certain debt instruments that must be converted to common or preferred stock at maturity. Total capital consists of primary capital plus secondary capital instruments—such as limited-life preferred stock and certain qualifying debt instruments. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 5 - Finally, we have used the enforcement process, when appropriate, to require banking organizations to restore or strengthen their capital bases. From our perspective, these guidelines and procedures have worked reasonably well. Since their adoption in 1981, the banking system has raised significant amounts of new capital, and capital ratios in the industry, particularly those of the larger institutions, have shown marked improvement. For example, at year-end 1981, the average primary capital ratio for the nation's 50 largest bank holding companies stood at 4.7 percent. By the end of 1986, this ratio had climbed to 7.1 percent—well above the minimum guideline level of 5.5 percent. While helping to encourage the reversal in the earlier downtrend in capital ratios, the guidelines may have also had some unintended, side effects. Because the current capital standards are based on simple capital to total assets ratios, they have created an incentive for banks to move or keep certain exposures off their balance sheets. In recent years, new Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 6 - financing and hedging techniques have in any event induced a very large growth in off-balance sheet liabilities of major banks, none of which are factored into our current capital standards. In addition, because our existing capital standards treat all bank assets alike, they have had the effect of encouraging some institutions to scale back their holdings of relatively liquid, low-risk assets. These developments suggest that the improvement we have seen in capital ratios in recent years overstates the real improvement in capital positions, measured against more realistic measures of risks. In an effort to address these shortcomings, the Board issued for public comment in early 1986 a proposal for a risk-adjusted capital ratio. The specific objectives of this proposal were to require an appropriate level of capital support for off-balance sheet exposures and to temper incentives in the existing guidelines that might encourage banks to reduce their holdings of low-risk assets. An equally important objective of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis this proposal was to move U.S. bank capital policies more closely in line with those of other major industrial countries. International Convergence This latter objective is particularly important in light of the increased involvement of banks in overseas activities and the growing interdependence of world financial markets. Because of this interdependency, supervisory authorities need to ensure that prudential rules and standards are sufficient to guarantee the stability and smooth functioning of the international banking system. The globalization of markets has also brought about a dramatic increase in international competition and an awareness that differences in rules among supervisory authorities around the world can create competitive distortions. The competitive disadvantages this could cause might make some supervisors more reluctant or less able to take otherwise necessary desirable supervisory actions, knowing that the end result of such actions could be a loss of competitiveness for their banking systems. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 8 - In light of these concerns, greater comparability in the prudential standards of major industrial countries has been discussed by regulators around the world for several years. Much groundwork has been laid in such international supervisory forums as the Committee on Bank Regulatory and Supervisory Practices ("Basle Supervisors' Committee"). In addition, the U.S. Congress, as you are aware, has recognized the importance of adequate capital levels for banking organizations and has been instrumental in encouraging the bank supervisory authorities to take further action in this area. In particular, the International Lending Supervision Act of 1983 directed the Federal Reserve and the U.S. Treasury Department to "...encourage governments, central banks, and regulatory authorities of other major banking countries to work toward maintaining, and, where appropriate, strengthening the capital bases of banking institutions involved in international lending." Critical to achieving this objective, of course, is a more internationally consistent definition of capital and comparable Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 9 - procedures for assessing capital adequacy in relation to banking risks* Description of U.S./U.K. Capital Proposal In developing the capital proposal, we wanted a framework that could meet, as effectively as possible, several partly conflicting objectives. First, the approach needed to address the rapid growth in off-balance sheet exposure and avoid disincentives to holding liquid, low risk assets. Second, we wanted to avoid any sense that capital requirements would be used as a tool for encouraging the allocation of credit to particular sectors, and we also wanted to avoid excessive complexity. Finally, we sought a framework that, while providing a clear basic structure for analysis, could be sufficiently flexible to enable supervisory authorities, as they evaluate individual banks, to take into account the many factors that affect overall risk that cannot be incorporated in any single formula. The approach that we have agreed upon among the U.S. authorities and with the Bank of England has three fundamental Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 10 - elements: a common definition of capital, a common risk-weighting framework for relating capital to risk assets and off-balance sheet items, and a common minimum capital requirement. The proposal defines primary capital to include the basic elements of common stockholders1 equity and general loan loss reserves. In addition, the definition provides for the inclusion in primary capital of other instruments such as perpetual and long-term preferred stock, as well as debt securities that meet certain conditions relating to permanence and loss absorption capacity. While the primary capital definition gives banking organizations some flexibility in building their capital bases, the proposal contains provisions to ensure that common stockholdersf equity remains the predominant form of bank capital. In the past, the U.S. regulatory authorities have accommodated reasonable innovations in the development of primary capital instruments. In a similar fashion, this proposal also provides room for an appropriate degree of flexibility, consistent with the basic need for an adequate equity cushion. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 11 - The second element, the risk weighting system, is the heart of the proposal. This component establishes a framework for ranking the relative riskiness of broad categories of assets and off-balance sheet exposures* For practical reasons, we tried to avoid developing a risk measurement system that would attempt to gauge all of the various types of, and subtle differences in, risk faced by banking institutions. Instead, we focused primarily on credit risk, although interest rate risk and liquidity considerations are taken into account to a limited extent. The proposed risk weighting system establishes five risk categories that reflect in a general way the relative magnitude of risk of the obligations assigned to the category. A bank's assets would be divided among the five categories according to the degree of credit risk of the borrower or obligor. Low risk assets, such as U.S, Government securities and short-term bank claims, would be assigned lower weights and, therefore, require less capital than they do under our present system. Normal Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 12 - commercial and individual loans would generally be assigned to the standard risk category, thereby requiring more capital than the lower risk assets. Off-balance sheet exposures that involve risks analogous to loans are treated in the same manner as direct extensions of credit. Other contingent items are also included in the risk framework, but only after the face or principal value of such items is adjusted to arrive at an on-balance sheet equivalent amount. In formulating this framework, we made some basic assumptions. Domestic governments, for example, are assumed to be generally less risky than other obligors because of their power to levy taxes and create money. Short-term claims on banks are also accorded low risk treatment, because of supervision and "safety nets" provided by most governments to their banking systems and to facilitate the smooth functioning of the interbank markets. Most private sector loans are assigned to the standard risk category without regard to the industry in which the borrower operates, the purpose of the loan, or, with a few Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 13 - exceptions, the collateral backing the loan. Obviously, the assignment of assets to risk categories, as I have already suggested, involves some arbitrary judgments at the margin and is certainly not an exact science. The third element of the proposed agreement is the supervisory ratio requirement. The U.S./U.K. proposal calls for a minimum, publicly announced ratio that would represent a common and equitable standard against which all U.S. and U.K. banks would be compared. The decision on where to set the minimum risk-based ratio has not yet been made. Obviously, the establishment of the minimum requirement will involve important considerations of safety and soundness, as well as a sensitivity to the effect of the minimum on pricing and competitive factors. Banks with a high level of quality liquid assets and a low level of off-balance sheet liabilities will not be affected by the proposal whereas those banks with large contingent exposure and lower liquidity levels may require adjustment. In any respect Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 14 - the proposal would be implemented in the context of a minimum capital standard. It is primarily the largest banking organizations th \t are engaged in the activities addressed by the risk-based capital proposal; the overwhelming majority of smaller banks will probably be unaffected. Even among the larger institutions, the impact of the minimum risk-based ratio will vary. Some institutions may find it necessary to strengthen their capital bases or reduce their overall level of risk, including off-balance sheet exposures; others may find that on a risk-adjusted basis their capital positions look even stronger* Absent other supervisory concerns, such institutions may have room for further prudent growth and expansion. We at the Federal Reserve intend to use the risk-based ratio to supplement our existing capital guidelines program, at least until sufficient experience is gained with the risk-based standard to justify relying on it more fully as a measure of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 15 - capital adequacy. The effect of this is to maintain a reasonable floor below which, under normal circumstances, capital to total assets ratios would not be allowed to fall. The interest of the government in maintaining some maximum leverage constraint or, put in different words, some minimum capital to total assets ratio seems, entirely consistent with the freedom of banks to change the composition of their assets and the nature of their business within broad limits. It is important to point out that the risk-based ratio would be but one element in the assessment of a bank's capital position. The on-site examination, together with other important components of our supervisory program, will continue to be the principal means for evaluating a bank's overall financial condition. Thus, those critical factors that affect a bank's soundness, but which are not factored into the risk-based ratio, such as earnings, loan diversification, liquidity, asset quality and collateral, operational risks and management will continue Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 16 - to play a central role in our final judgments on capital adequacy• Pricing and Comp titive Considerations I cannot emphasize strongly enough our interest in the competitiveness of U.S. banks. Only a strong, competitive and profitable banking system can remain healthy in the long run and fulfill the strategic role banks play in our economic and financial system. In considering the issue of competitiveness, it is possible that banks that are permitted to operate with lower capital levels may have a competitive advantage, at least in the short run, over banks that are required to meet higher capital standards, But, from the standpoint of appropriate public policy, those considerations have to be balanced against the long-run safety and soundness of the banking system* In striking that balance, questions have inevitably been raised about the effects of the risk-based proposal on U.S. banks1 ability to price competitively certain banking services. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 17 - This is especially true of those off-balance sheet instruments, such as loan commitments, letters of credit and interest rate and foreign exchange rate contracts, that are being explicitly factored into our capital ratios for the first time. As I have indicated, one of the major objectives of risk-based capital is to address the rapid growth of off-balance sheet exposures, and bankers themselves clearly acknowledge that these instruments involve some credit risks. In addition, logic and experience suggest that certain indirect extensions of credit or financial guarantees can involve risks that are similar to those stemming from direct loans. We are aware of the potential pricing implications of the risk-based proposal, and have sought specific comment on how the proposal may affect the ability of banks to compete in the provision of certain services. And we will, of course, carefully consider the comments we receive. However, I am concerned that competitive pressures may have eroded spreads on some of these instruments to the point that banks are not being fully Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 18 - compensated for the credit risks involved. To the extent this is the case, the risk-based capital proposal may encourage a more rational and appropriate pricing structure that is consistent with the long-run stability and health of our banking system. Another dimension of this issue relates to the capital requirements of nonbank financial institutions that have become major competitors of commercial banks. In my view, as U.S. banks come into increasing competition with nonbank financial institutions, including thrift institutions and investment banks, appropriate efforts should be made to ensure that capital requirements among different institutions conducting the same activities are brought into closer alignment. For this reason, we strongly"support the steps taken by the Federal Home Loan Bank Board to encourage thrift institutions to strengthen their capital positions* The need for parity of capital standards on an international basis is no less pressing. And, of course, as I have indicated before, that is an important objective of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 19 - U.S./U.K. proposal. The prospect of major international banking organizations operating throughout the world with vastly different capital requirements and capital resources is not, in my view, in the best long-run interest of sound, stable and competitive international banking and financial markets. Thus, it is our hope that banking supervisors in other major industrial countries will examine the risk-based capital proposal with a view toward bringing their policies—to the extent possible—into closer alignment with the type of framework spelled out in the U.S./U.K. agreement. In the past, we have not applied extraterritorially U.S. bank capital standards on a consolidated basis to foreign banking organizations seeking to expand in the U«S. However, the U.S./U.K. risk-based capital proposal represents a step toward a more consistent and equitable international norm for assessing capital adequacy. For this reason, we believe such a framework can, under appropriate circumstances, assist in evaluating the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 20 - capital positions c: foreign banks applying to acquire U.S. institutions. Conclusion The internationalization of banking and financial markets and the intensification of competition among multinational institutions underscore the importance of efforts to better rationalize and harmonize the competitive and prudential framework within which banks must operate. Despite the progress embodied in the U.S./U.K. proposal, however, much remains to be done. We recognize that significant differences among countries in banking, accounting, and supervisory and regulatory practices suggest that progress toward achieving greater consistency on an international level may be gradual' and involve difficult and complex discussions. Nonetheless, I can assure you that the Federal Reserve is committed to working with supervisors from other countries to encourage the development and adoption of more consistent and broadly accepted international capital standards. In the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 21 - meantime, I believe that adoption by U.S. regulators of a framework along the lines of the U.S./U.K. proposal, while far from perfect, represents a reasonable step toward a more rational framework for relating the analysis of capital needs to risk considerations. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Paul A. Volcker (1987, April 29). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19870430_volcker

@misc{wtfs_speech_19870430_volcker,
  author = {Paul A. Volcker},
  title = {Speech},
  year = {1987},
  month = {Apr},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19870430_volcker},
  note = {Retrieved via When the Fed Speaks corpus}
}