Statement by Richard Spillenkothen - Federal Reserve System Banking Supervision and Regulation Director Richard Spillenkothen - Statements to the Congress

Federal Reserve Bulletin,  May, 1996  

Tags: Federal Reserve Board, risk management, U.S. Congress

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Thank you for the opportunity to discuss the, Federal Reserve's efforts to increase the focus of examiners and other supervisory personnel on the risk management procedures of banking organizations. The subject of "risk management" has attracted much attention in recent years both in the financial community and among the US. bank supervisory agencies and is a timely topic for discussion with this committee. Improvements in risk management procedures have clearly affected the way in which many banks manage their activities and the agencies review them. Advances in risk management techniques have also permitted expanded product lines and more efficient services, while providing methodologies that, if used properly, can enable institutions to better control the risks associated with ever more complex financial instruments and growing volumes of transactions.

Risk management is the process of identifying, measuring, reporting, and control the risks, which banks and other businesses have always done. In that sense, it is nothing new. What is new is the technology that has facilitated product innovation and the application of financial theory to the development of new products. Many of the new products are highly complex and are not best addressed by examination on a transaction-by-transaction basis or by simply verifying balance sheet values. Moreover, these products highlight the importance of managing a broad range of risk in addition to traditional credit risk. These risks include potential exposure to market, liquidity, operational, legal, reputational, and other risks.

Increasingly, therefore, the Federal Reserve has engaged in a concentrated effort to focus the attention of examiners on evaluating the adequacy of a bank's processes for identifying, managing, and controlling all of its risks when developing conclusions about the overall safety and soundness of the institution. While management processes at all banks may deserve more attention, this focus is particularly important at large institutions that conduct substantial volumes of transactions daily, deal in highly complex instruments, and can significantly alter their risk profiles on relatively short notice.

Let me emphasize that the traditional approach of evaluating the quality of a bank's existing assets (that is, its loans and investments) remains highly important to the Federal Reserve's supervisory process. Our long-standing practice of reviewing credit risk in a bank's portfolio (including the counterparty credit risk in derivative instruments) is not being de-emphasized. While recent attention has focused lately on trading activities and complex instruments, the possibilities for misadventures extend throughout a bank, and we cannot forget the lessons of the past. Not long ago, large institutions were experiencing serious problems with excessive commercial real estate lending - problems brought about by policies and lending practices that were inconsistent with market realities and principles of sound credit risk management. In addition to asset quality, our examiners will continue to focus on other important and traditional financial indicators, such as capital adequacy, earnings, and liquidity.

Still, technology and innovation have presented banks with new ways of both taking and managing risks. With the advent of off-balance-sheet, over-the-counter derivative instruments, for example, institutions of all sizes can adjust their yields, risks, and liquidity much easier and quicker than they could before, with either positive or negative results. Accordingly, by itself, an assessment of the quality of a bank's loans, investments, and other balance sheet values at a point in time no longer provides the assurance it once did that a sound institution is likely to remain sound in the future. Losses at Barings PLC and other institutions have shown how rapidly the financial strength and condition of a bank can change and demonstrate that it is essential for management to implement and enforce sound controls and risk management practices that are appropriate for the activities the firm conducts. In the Barings case, it was not risky instruments or credit risk but poor controls over the actions of a rogue trader that broke the bank. Indeed, a breakdown or an absence of internal controls or risk management systems has been the fundamental cause of recent financial problems at several institutions.

Bank supervisors cannot be everywhere; nor can they prevent every problem. Moreover, too much supervision and government oversight would simply stifle innovation and lead to a less competitive and responsive financial system. Relying more on supervisory techniques that encourage banks to adopt procedures to prevent excessive risk-taking - while keeping in place fundamental prudential safeguards such as adequate capital cushions - minimizes our intrusion while at the same time enhancing safety and soundness.

Management and the institutions themselves, not supervisors, must be the principal source for detecting and deterring abusive and unsound practices through adequate internal controls and operating procedures. Particularly at large institutions, market discipline can also play an important role, provided the institutions make adequate disclosures. By emphasizing these points through focused, risk-oriented examination procedures and efforts that promote sound disclosure and accounting standards, supervisors hope to increase the likelihood that a bank's activities will remain sound for the long term.