Chapter

Chapter 5 Prudential Supervision of Banks and the Basle Core Principles

Author(s):
International Monetary Fund
Published Date:
August 1999
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This paper deals with the general subject of prudential supervision of banks and the Basle Core Principles. Clearly, bank supervision is a very hot subject these days in many countries, and there is plenty to talk about.

In recent years, we have witnessed dramatic changes in the business of banking, driven by such key evolutionary factors as globalization, deregulation, technological changes, financial innovation, and the growth of ever larger financial conglomerates.

Collectively, these various developments have given rise to major challenges, not just for bankers but also for bank supervisors. And over the past decade, we have experienced significant banking problems in many countries, both large and small, industrial and developing. In their wake, serious questions have been raised about the adequacy of bank supervisory techniques and overall performance, and about the need for fundamental changes in the approach to supervision.

While recent attention has focused on the situation in Asia, the issue is clearly a global one. Indeed, in the United States we have had our fair share of banking sector difficulties in the not-so-distant past. And these experiences have certainly helped to shape my own thinking concerning an appropriate supervisory framework for the future.

This paper is divided into six basic parts.

  • First, I’ll comment on the important role played by bank capital.

  • Second, I’ll talk about my view of supervision as a three-legged stool, with clearly defined roles to be played by individual firm management, by the broad market place, and by the official sector.

  • Third, I’ll comment on the U.S. approach to bank supervision and how it is working.

  • Fourth, I’ll briefly discuss the Basle Core Principles for Effective Banking Supervision, which I view as an important initiative to raise the quality of prudential supervision at the international level.

  • Fifth, I’ll mention a few of the other major projects under way at the Basle Committee, which are also aimed at strengthening the safety and soundness of the global financial system.

  • Finally, I’ll conclude with some thoughts on the challenges posed for all of us by the Year 2000 computer problem, which I regard as potentially very serious.

Changing Role of Bank Capital

Let me turn first to the role of bank capital, which, as you all know, plays an essential role in the management and supervision of banks. First and foremost, capital serves as a source of financing for the banks. At the same time, capital can help prevent losses by influencing the risk appetite of owners and managers. And should an institution experience unexpected losses, its capital will serve as a source of strength or a buffer to help absorb the losses. And equally important, measures of capital can play a very useful role for all market participants by facilitating financial comparisons among banks.

The Basle Accord

At the global level, the adoption of the 1988 Basle Capital Accord was, without question, a milestone achievement in international supervisory cooperation. For the first time, supervisors from the Group of Ten countries—and indeed from most countries with internationally active banks—agreed to minimum capital requirements to which they would voluntarily adhere.

The accord also was precedent-setting in that it tied capital requirements to the riskiness of a bank’s portfolio of assets, and incorporated off-balance sheet instruments into the capital calculation for the first time. In this manner, the accord has helped to encourage a more risk-focused attitude among both banks and their supervisors.

In the wake of the capital accord, the capital ratios of large international banks have, on average, increased significantly. With the benefit of hindsight, this proved to be a good thing given the asset problems that banks in many Group of Ten (and non-Group of Ten) countries have encountered since the signing of the accord in 1988. But, as precedent-setting as the Basle accord was at the time, we all recognized that it was only a first step down a pretty long path and that further steps would be needed.

For one thing, the accord addressed only the credit risk associated with a bank’s on- and off-balance sheet positions. It did not seek explicitly to cover other types of risk such as market, liquidity, and operational risk, although the Committee did indicate its intention to incorporate market risk at a later date.

Moreover, the original accord was designed to provide only a broad framework for risk weighting of a bank’s exposures. It was hoped that this approach would result in a reasonable measure of a bank’s riskiness on a portfolio basis—even if it resulted in over- or underestimates of the riskiness of particular assets.

While this approach had its appeal, there were some obvious, and recognized, shortcomings. For example, loans to commercial counterparties all received the same risk weight, whether the loan was to a highly creditworthy firm for low-risk working capital purposes, or to a marginal firm for highly speculative commercial real estate development.

The Market Risk Amendment

The next major breakthrough on capital took several more years to achieve—culminating in a decision by the Basle Committee in January 1996 to extend the capital accord to cover market risk. In my view, the Basle Capital Accord’s market risk amendment—which went into effect in January of this year—was a major development in the capital area.

It represented a dramatic shift in capital regulation, moving away for the first time from the prevailing approach of a mandated and rigid regulatory formula toward a more market-based and discretionary approach.

The new approach draws on banks’ internal methodologies for risk measurement, places greater emphasis on promoting sound risk management and control processes, and encourages further innovation and improvement in the banks’ internal models. But, while recognizing the importance of the market risk amendment, I must emphasize that the Basle Committee’s work on capital is by no means finished, and I’ll come back to this theme later on.

Firm Management, Market Discipline, and Official Supervision

Despite the critical role that capital requirements should and must continue to play in the overall supervisory process, we should not assume that capital supervision alone will ever ensure a safe and sound banking system. To the contrary, all the capital in the world won’t be enough if a rogue trader or loan officer is able to operate recklessly or fraudulently in an environment lacking sound internal controls and proper risk management systems. Indeed, the landscape is littered with the carcasses of banks that—immediately prior to their demise—had been thought to be well-capitalized and fundamentally strong.

I am convinced that appropriate capital must be complemented by effective management at the firm level, as well as by market discipline and by meaningful official supervision. As I see it, each level of supervision should address those areas where it has the comparative advantage.

Firm Management

At the firm level, the Basle Committee and others have supported the principle that effective management supervision is the first and most important line of defense against potential problems. And in my opinion, this will increasingly be the case, as financial institutions become ever more global and more complex.

Active oversight by senior management and the board of directors of a bank’s businesses and its accompanying risks is absolutely essential. Bank management possesses the most intimate awareness and understanding of the risks facing its institution and has the ability to ensure a strong system of line supervision. In addition, bank management is best positioned to ensure that adequate information systems and procedures are in place to effectively manage those risks.

And to carry out effectively these managerial responsibilities, the institution must also have truly independent and clearly defined risk management, internal control, and audit functions—with direct reporting lines to senior management and regular reporting to the board of directors.

Market Discipline

At the market level, oversight takes the form of what we commonly refer to as market discipline. Market discipline can and should play a critical, catalytic role in influencing bank management to make sound decisions regarding the operations of the bank. Greater transparency will, without question, enable market participants to make better-informed judgments about with whom and to what extent they are prepared to do business. And I strongly support further steps in this direction.

In the accounting area, where agreement on international standards is easier said than done, an important first step would be to understand better the major differences that exist in national accounting conventions. We simply must get to the point where both supervisors and market participants alike can compare all global financial institutions on a consistent basis. And, of course, until we have greater harmonization of international accounting standards, we will not have truly comparable international capital standards.

Official Supervision

While oversight at the firm and market levels is clearly of utmost importance, I would stress that, in my judgment, neither can substitute for the critical role played by official supervision. Just as firm management and market discipline possess certain advantages, supervisors also offer their own set of comparative strengths.

First, and foremost, banking supervisors are better positioned and more inclined to focus attention on systemic risk and other important, longer-term public policy issues than the individual firm or the broad marketplace—with their necessarily greater focus on shorter-run financial performance.

Second, banking supervisors have undeniable advantages in obtaining and assessing certain types of information. For one thing, we have more extensive and more timely access to sensitive information than markets are ever likely to have. For example, by virtue of our supervisory authority, we have direct and immediate access to proprietary information on all the banks that we supervise, including their management information systems and internal controls. And we have the unique ability to compare any bank’s management and control processes, as well as its financial performance, against those of its peers.

Supervisors also are well-positioned to provide the industry with guidance on what we believe to represent “sound practices,” particularly in areas of risk management and control. By virtue of our in-depth knowledge of how all firms we supervise are managing their risks, we are uniquely positioned to assess which practices are sound and which are not—and to provide appropriate feedback to the industry. This, I believe, is one of our major comparative advantages and something the supervisory community should strive to do much more of.

Third, my own experience strongly suggests that banking supervisors are also needed to enforce compliance with applicable laws and regulations, both in good times and in bad.

And finally, it is clear to me that only banking supervisors have the requisite knowledge and clout to assure that prompt corrective actions are taken when serious financial or other problems are identified, particularly if they are not visible to the market generally.

For all of these reasons, I believe that each of these approaches to oversight—effective bank management, market discipline, and official supervision—can and should work together and reinforce each other in order to assure a safe and sound banking system.

Supervision in the United States

Now that I have described to you my views on the appropriate division of labor between management, regulators, and the market, let me turn to the issue of how bank supervision has evolved in the United States in recent years, and where I believe we should be headed.

Risk-Focused Supervision

In the past few years, we have worked very hard to keep our supervisory approach in line with the rapid changes taking place in the banking, and indeed, the financial industry more generally. How does one effectively oversee the activities of an institution given such a dynamic environment? This is a question that not only bank supervisors must constantly grapple with, but also boards of directors and senior bank management. I have gradually come to the conclusion that the only practical solution for supervisors is to take a more risk-focused and process-oriented approach to our regular, on-site examinations.

By “process oriented,” I mean our examiners should focus much of their attention on whether a bank’s risk management processes and overall control environment are adequate, given the nature of its business. While traditional supervisory tools, such as transactions testing and account reconciliation, should continue to play a role, the extent of their use by examiners should be reasonably calibrated to their assessment of the bank’s risk management and control processes.

At the New York Federal Reserve Bank, the increased emphasis on risk-focused, process-oriented supervision can be seen in a variety of initiatives. These include the following:

  • First, growing attention to the development and dissemination of “sound practices” papers to the industry. For example, last year the New York Federal Reserve Bank undertook a comprehensive review of private banking activities at about 40 domestic and foreign banking organizations. Based on the findings, the Federal Reserve issued a sound practices paper providing guidance on basic controls to minimize reputational and legal risks and to deter illicit activities such as money laundering.

  • Second, building on this successful model, the New York Federal Reserve Bank has established a number of “specialty examiner teams” to develop greater expertise on a wide range of subjects, such as credit risk modeling, foreign exchange risk management, liquidity management, asset securitization, and emerging markets trading. We hope many of these teams will also produce useful sound practices papers in the future.

  • Third, we have sponsored a series of conferences on several risk-related issues of interest to supervisors and the industry, such as bank capital, financial disclosure, private banking, information security, and the Year 2000 problem. These conferences have brought together regulators, financial practitioners, and academics with an eye to gaining a better understanding of emerging industry trends and to developing improved supervisory techniques.

Lessons from the Late 1980s and Early 1990s

The role of the bank supervisor, while never dull, is particularly challenging in times of financial stress. And, as I mentioned earlier, the United States has had its share of banking problems.

The late 1980s and early 1990s were a period of significant stress in the United States, and I thought you might be interested in a brief summary of how we worked with our banks to address those problems and some of the lessons we learned from that experience.

The 1980s was a period in which bank balance sheets were steadily weakened by the combined impact of the developing country debt problem, loan concentrations to a number of troubled sectors, such as energy, agriculture, and shipping, and the serious commercial real estate problem that surfaced in the late 1980s.

Our examiners had observed a growing deterioration in asset quality, with spillover effects on earnings and capital during this period. They also saw signs of deterioration in the internal control environment at several of the banks. And they noted their concerns in their examination reports and downgraded their supervisory ratings of individual banks. The initial response of bank management to the downgrades was typically one of denial. However, as the situation continued to worsen and our supervisory comments intensified, most senior bank managers, to their credit, came to recognize the potential seriousness of the situation.

At the request of the Federal Reserve, problem banks submitted detailed financial plans describing how they would address their various financial difficulties. The plans reflected both the Federal Reserve’s and their own initiatives and included to varying degrees a mix of the following:

  • the raising of significant amounts of new capital;

  • the aggressive write-off of bad loans;

  • strict limitations on asset growth;

  • the sale of poorly performing assets and unprofitable business lines;

  • a sharp reduction in operating expenses, primarily through staffing cuts;

  • the development of contingency funding plans in the event of liquidity problems;

  • the reduction or total elimination of dividends;

  • more active involvement by the bank’s board of directors and, in some cases, changes in senior management; and,

  • from a contingency standpoint, the consideration of possible merger candidates as a last resort.

While this period presented difficult challenges—both for bankers and their supervisors—the good news is that the program was highly successful. Once the bankers accepted the severity of their problems, they moved aggressively, in partnership with their supervisors.

And given where our banks were less than a decade ago, it is remarkable to see the transformation that has taken place. By virtually all measures—asset quality, capital adequacy, earnings, and so forth—these banks are now fully recovered.

In retrospect, perhaps the principal lesson to be learned from the U.S. experience is that when supervisors see storm clouds on the horizon—or worse yet forming directly overhead—it is imperative that they move quickly to get the full attention of bank management and their recognition of the need for prompt remedial action. History has shown time and again, in the United States and elsewhere, that the longer an institution waits to address its problem, the harder it will be to manage. Unfortunately, the temptations to try to muddle through can, at such times, be almost irresistible.

An equally important, and related, lesson is that for the supervisory process to work well, it must be based on a strong sense of confidence and partnership between the supervisor and bank management. As I see it, it is the supervisor’s responsibility to keep on top of changing business activities in the banking sector, but to do so without stifling innovation in the process. You might say it is our job to stay one step, but only one step, behind the industry.

To do this, effective supervision requires candor, cooperation, and open channels of communication with bank management—in both good and bad times. And we must recognize that, from time to time, problems can arise at any bank—after all, banks are in the basic business of assuming and managing risks.

However, we are also very aware of how managers respond on those relatively few occasions when trouble arises—and whether they inform us promptly and fully of the nature of the problems. When so informed, our objective—to the maximum extent possible—is to be part of the solution rather than part of the problem. But where we feel we have not received full and timely cooperation, we will take a much different and tougher stance. The Daiwa Bank episode in 1996 was a good example. As you may recall, Daiwa’s problems in New York reflected serious fraud and a breakdown in management supervision and controls. But, in my opinion, it was not the disturbingly weak control environment that led us to require Daiwa to close its U.S. operations. Rather, it was the fact that senior management of Daiwa—and not just local management in New York—had engaged in what we felt was a concerted effort to mislead the regulators for well over a decade.

To my mind, the supervisory process must rely on the honesty and integrity of a bank’s management. Without basic confidence and trust in management, I do not believe that we can realistically supervise any organization effectively.

Financial Sector Reform

Let me now turn briefly to the subject of U.S. financial sector reform. While Europe, Japan, Latin America, and many other parts of the world have taken action to rationalize their financial systems, the U.S. Congress continues to debate the critical issue of financial sector reform with little to show for it.

Hopefully, the recently announced proposed merger between Citicorp and Travelers Group—a major U.S. insurance and securities firm—will finally induce Congress to adopt a national policy framework to support the rational development of our financial services sector. But whether or not there is near-term legislative reform, the rapid changes in the global financial services industry will require both supervisors and senior bank managers to rethink what it means to oversee the activities of firms that increasingly operate across different financial sectors and different time zones.

In a perfect world, I would argue that every financial organization large enough to represent a potential threat to the global financial system should be subject to meaningful consolidated oversight by a qualified supervisory authority. I should emphasize that I am not suggesting that our current bank supervisory model should be extended to all large financial services firms. Rather, I believe that we should be able to achieve effective consolidated oversight through a more limited model—coupled with appropriate residual authority for dealing with problem cases.

Some of the key elements of the type of more limited model I have in mind include

  • designation of an umbrella supervisor to coordinate the overall supervisory process, relying to the maximum extent possible on the work of functional supervisors;

  • some means of assessing the adequacy of consolidated capital levels, focusing in particular on double leverage;

  • qualitative standards for the management of inter-affiliate exposures, perhaps supplemented by quantitative limits, as necessary;

  • an ongoing dialogue with the conglomerate’s senior management and board of directors on key strategic and managerial issues; and

  • very importantly, periodic reviews of the conglomerate’s risk management and internal control systems.

The Citicorp/Travelers merger should provide us with a good opportunity to experiment with a new, and relatively more narrow, supervisory model.

Core Principles for Effective Banking Supervision

Let me now turn to the work of the Basle Committee, starting with the Core Principles for Effective Banking Supervision.

Core Principles

The decision to develop the Core Principles largely reflected a growing realization that inadequate bank supervisory systems had been a major contributor to the financial difficulties in many countries. Indeed, the importance of effective prudential supervision has been a subject of discussion at the two most recent Group of Seven Summit meetings, in Lyon and Halifax. In response to this growing interest, the Basle Committee—working closely with supervisors from 15 non-Group of Ten countries—developed a set of 25 Core Principles for use by both industrial and emerging market countries.

The principles cover a broad range of topics, including licensing and structure, prudential regulations and requirements, methods of ongoing banking supervision, information requirements, formal powers of supervisors, and cross-border banking. They are intended as minimum requirements, and it is expected that national supervisors will strengthen them as necessary to address the specific circumstances of their local systems.

A number of the Core Principles address key prudential supervisory issues, including capital adequacy, loan loss reserves, asset concentrations, liquidity, risk management, and internal controls.

On the crucial subject of risk management, the principles state that bank supervisors must be satisfied that their banks have in place risk management systems that accurately identify, measure, monitor, and control market risks and other material risks. In addition, the banks are expected to hold an adequate amount of capital against those risks.

In a real sense, the principles reflect a growing expectation that banks must bear the principal responsibility for adequate risk management themselves. Translating the Core Principles into practice at the individual country level is a major undertaking. In fact, in some countries, legislative changes will be necessary to provide supervisors with the authority needed to effectively carry out their responsibilities.

In preparation for the International Conference of Banking Supervisors held in Sydney in 1998, the Basle Committee conducted a survey on the status of efforts by national supervisors to implement the principles. At the fall conference, I would hope that the Core Principles will receive broad-scale endorsement—and indeed, a number of countries have already done so.

Following the conference, I expect the Basle Committee to play an ongoing role in facilitating the actual implementation of the Core Principles. This role should include

  • coordinating with Group of Ten and non-Group of Ten supervisors in identifying issues that may arise during implementation of the Core Principles;

  • interpreting the principles and issuing additional principles as needed; and

  • providing technical assistance and training to countries working to adopt the principles. To this end, the Bank for International Settlements (BIS) is establishing a new body—the Institute for Financial Stability—to serve as a training center and as a clearinghouse for the provision of technical assistance to supervisors around the world.

In addition to the role of the Basle Committee, I also see a role to be played by the IMF and the World Bank, in regard to the critical need to monitor the success of national supervisors in implementing the Core Principles. This is a task that the Basle Committee is not well positioned to take on. We lack both the resources to do so, and the authority. The IMF and the World Bank, on the other hand, are better positioned to monitor compliance with the principles, presumably as part of their national surveillance programs. My understanding is that both agencies have agreed to take on this task, and I envision close coordination and cooperation between the Basle Committee and the two agencies going forward.

Other Important Basle Initiatives

Having discussed the Core Principles, let me briefly touch on some other important Basle initiatives aimed at strengthening the underpinnings of the global financial system.

Capital Requirements for the Future

First, let me return to the issue of capital standards. While the Basle Capital Accord was only just amended to incorporate market risk, many of us believe that it is not too early to begin thinking about the next generation of capital requirements—particularly given the long lead times involved in introducing change. Among some of the issues that need to be addressed are the following:

  • The highly sophisticated internal models approach used to measure market risk is hard to reconcile with the relatively simple approach to measuring credit risk set forth in the original Basle Accord.

  • It remains unclear whether other critical risk areas, such as operational, liquidity, reputational, and legal risks, should be explicitly covered by the accord and, if so, how that should be done.

  • Supervisors have thus far taken a building-block approach to capital. This contrasts with the overall direction of the industry, where banks seem to be moving toward a more integrated approach to the measurement and management of their various risk exposures.

  • The accord does not address the key question of how to assess the consolidated capital position of the growing number of internationally active financial conglomerates, which combine banking, securities, and insurance activities in a single group.

Moreover, it is clear that market participants are developing ever more ingenious new instruments and techniques to avoid the full impact of the accord’s current capital requirements. To spur consideration of these various capital-related issues, the Federal Reserve Bank of New York and the Board of Governors of the Federal Reserve System recently co-sponsored a Capital Conference with the Bank of England and the Bank of Japan. The conference was attended by academics, bankers, and regulators—including a majority of the members of the Basle Committee—and it provided a forum for debate on a wide spectrum of ideas about future capital regulation.

While no consensus was reached, all participants came away from the meeting with the realization that we are dealing with a very complex issue and that there are no quick fixes or one-size-fits-all solutions. It also was clear that the public and private sector will need to work closely together if a practicable way forward is to be found. To my mind, capital remains the number one issue on the Basle Committee agenda.

Standards for Risk Management and Internal Controls

A second key issue before the committee is the need to develop stronger risk management and internal control standards for the banking industry. While I believe that considerable progress has been made over the past few years, we continue to see serious breakdowns in risk management and internal controls at major global institutions, and clearly further work needs to be done. In this context, I’d take note of two important initiatives that are now in the pipeline—one public sector and one largely private sector.

  • First, the Basle Committee established a Risk Management Sub-Group last year to focus on risk management and control issues, and to provide guidance to the industry in this area. The sub-group recently issued a report identifying over a dozen basic principles for strengthening a bank’s control environment—and its work on risk management is ongoing. For example, it is now tackling the issue of how to improve practices for the credit risk management process.

  • Second, the Group of Thirty—a nonprofit public policy group—issued a report in 1997 urging, among other things, that the private sector take the lead in developing a set of principles for global financial firms to use in managing and controlling their risks. Moreover, the report contemplated that individual firm adherence to the principles would be validated through an independent, global audit, and that the results would be disclosed to the public in a consistent and meaningful way.

While it is too early to predict what will result from these two closely related initiatives, representatives of the Basle Committee and the Group of Thirty have opened a dialogue on possible areas for private/public sector cooperation. While it is clear to all that at the end of the day the supervisors must have the final say on what supervisory standards they impose, it is also clear to me that the final work product would benefit from active private sector input.

Enhanced Accounting and Disclosure Practices

A third issue before the Basle Committee is how to enhance the role of market discipline that, you will recall, is one leg of my three-legged stool. The key to effective market discipline is sound accounting and disclosure standards. While considerable efforts have been made to improve disclosure and accounting practices, particularly in regard to trading and derivatives activities, the recent problems in Asia show that we have more work to do. And the Basle Committee is working to address both issues.

We have one group focused on how to better harmonize international accounting practices for banks and another working to enhance general disclosure practices. Much of this work is concentrated on improving accounting and disclosure methods for valuation, and income recognition, of impaired loans. Time and time again, these are the areas where we have seen problems arise in the past.

Here, too, we are not alone in our efforts to strengthen accounting and disclosure practices for banks. A recent Group of Thirty report has suggested the need for both more uniform accounting standards internationally and more meaningful disclosure of financial and risk information. This seems to me to be yet another area that is ripe for private/public sector collaboration going forward.

Joint Forum

Another key issue before the international community is how to supervise the increasing number of internationally active financial conglomerates. As these entities engage in a wide range of businesses, which blend banking, insurance, and securities activities, they pose a significant challenge to existing supervisory systems.

The Joint Forum—comprised of supervisors from the banking, securities, and insurance sectors—has made concrete recommendations related to the development of supervisory techniques for financial conglomerates. These include ways to assess capital adequacy and to enhance the exchange of information among different supervisors.

The Basle Committee, in cooperation with the International Organization for Securities Commissions and the International Association of Insurance Supervisors, recently circulated these recommendations to participants in the banking, securities, and insurance industries for comment. From my vantage point, the proposed Citicorp/Travelers merger makes it all the more pressing that we make near-term progress on this important initiative.

The Year 2000 Challenge

Finally, let me close with some comments on what may be the biggest near-term challenge of all—the Year 2000 problem. I don’t talk to any bankers these days, or lawyers for that matter, without referring to the Year 2000 issue, and I certainly won’t pass up the opportunity to do so here. Unlike any other challenges we face, this one has a fixed deadline that cannot be postponed under any circumstances.

Let me first say that no market, no matter how developed, is immune from the difficult issues presented by the Year 2000 problem. U.S. financial institutions are grappling with the same problems faced by firms all over the world.

Let me also add that Year 2000 readiness is an enterprise-wide challenge that goes beyond issues of technology and that, without question, requires the full attention of a bank’s board of directors and senior management. That being said, I’d like to highlight a few of the issues that seem particularly relevant to me.

  • The Year 2000 problem affects a bank’s accounting, risk measurement, and control systems, cutting across both the front and back offices. Ensuring Year 2000 compliance therefore requires close coordination among business lines, operations functions, and risk management and control areas.

  • External vendors frequently provide many of the systems used in risk management, control, and audit functions. Needless to say, it is critical that these vendor systems also be Year 2000 compliant and that they be fully tested for compatibility with internal systems.

  • Banks must consider the state of Year 2000 readiness when assessing counterparty and customer credit exposures. A counterparty that is not Year 2000 compliant could experience difficulties that threaten its financial future and, even worse yet, its ability to repay its debts to its banks.

  • One of the most common ways for problems to be transmitted from one financial institution to the next is through the payments system. Thus, it is critical that a bank assess the Year 2000 compliance of all domestic and global clearing and settlement systems through which it conducts business. Making sure that payment and settlement systems are Year 2000 compliant is another area where the private and public sectors can and must cooperate closely—and I’m happy to report that, from where I sit, this cooperation seems to be gathering momentum.

In my view, supervisors must lead by example and provide guidance to the banking industry. And, in the United States, we have tried to do just that. For example, the federal regulatory agencies have issued supervisory letters to senior management of banks on several occasions to raise awareness of the Year 2000 problem. And we have sponsored industry conferences on issues such as outsourcing and the assessment of Year 2000 credit risk.

At the international level, the Basle Committee recently released a report entitled The Tear 2000: A Challenge for Financial Institutions and Bank Supervisors. In addition, the Bank for International Settlements hosted a roundtable discussion last month of international supervisors, payment system experts, and global bankers to draw further attention to the Year 2000 problem. And the Year 2000 issue will also be on the agenda for the International Conference of Banking Supervisors this fall in Sydney.

But despite all of our collective readiness efforts, I will be astonished if we don’t encounter some big-time surprises—including some firms that, when we get to crunch time, simply are not ready. While no one can anticipate exactly what surprises await us, I cannot overstate the importance of vigorous contingency planning by the global financial community—as well as by all relevant supervisors and central banks. And it goes without saying that we will need to allow ample time for testing, testing, and more testing.

Given all of the things that potentially could go wrong, I wouldn’t rule out the possibility that year-end 1999 could produce a very different kind of “big bang.” If, on the other hand, my concerns prove unfounded—and I certainly hope that they do—the worst that will happen is that we will all get to sit back and relax on New Year’s Eve, and raise a toast to the new millennium, and to our very, very good fortune.

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