Chapter

III Derivatives and Supervisory Issues

Author(s):
International Monetary Fund
Published Date:
January 1994
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Last year’s International Capital Markets report examined the growth of derivative markets, the role of wholesale banks in these markets, and the benefits and potential systemic risks associated with their continuing development.17 The losses incurred recently by several commercial firms undertaking derivative transactions (see Box 1) reinforces oft-repeated concerns that when a financial activity is growing very rapidly and attracting many new entrants, the probability of less experienced players getting into difficulty rises, with potentially adverse spillover effects for their lenders and counterparties. The first part of this section reviews the response of regulators to these challenges. The second part looks at two other timely issues in supervision, namely, the role of the central bank in banking supervision, and the adequacy of the existing approach to the supervision of nonbanks.18

Box 1Futures Shocks

One of the central recommendations of the Group of Thirty report on derivatives was that senior management must be kept fully informed of a firm’s operations in derivatives markets.1 Two announcements in December 1993 and January 1994 demonstrated the importance of this principle. In late January, the Chilean copper mining company Codelco—which accounted for 6 percent of Chilean GDP in 1993—announced that it had suffered losses of $206.8 million on copper futures trading in 1993. These losses apparently originated in a clerical error by the head futures trader who entered some of his transactions in his computer incorrectly. Despite a requirement to inform his superiors and to close positions when losses reached $1 million, he apparently kept this knowledge to himself and attempted to regain the original $30–40 million in losses by speculating in the futures markets. At one point in this operation, which proved disastrously unprofitable, he had taken positions that represented requirements to deliver twice Codelco’s annual production.

Six weeks earlier, similar problems at German metals and mining conglomerate Metallgesellschaft AG had come to light. MG Corp, a U.S. subsidiary, had sold five- and ten-year contracts to its customers to provide petroleum products at fixed prices. These contracts gave the customers the option to terminate the contract, at a cost equal to half the resulting profit, at any time—that is, if the spot price rose above the forward price. To hedge the exposure from these long-term options, MG Corp took a long position in the near-month futures contract, which is generally the most liquid contract, and rolled this position over each time the futures contract expired. Such a hedging strategy is profitable as long as the market is in “backwardation”—that is, the spot price exceeds the futures or forward price. However, by the end of November, the market had moved into “contango”—that is, the futures price exceeded the spot price—and MG Corp incurred losses when it rolled over its futures position. The fall in futures prices was reportedly due in part to MG Corp’s own transactions, which were swamping the market. By that time, MG Corp had an estimated 55,000 outstanding contracts in the New York Mercantile Exchange (Nymex)—almost twice the usual limit—and even more OTC positions (where the latter represented commitments to deliver 160 million barrels of oil—80 times the daily output of Kuwait).

At the end of November, MG Corp faced a margin call from the Nymex. It met the call only with the help of a DM 1.5 billion loan from Deutsche Bank and Dresdner Bank. Reportedly, it was only at this point that Metallgesellschaft’s supervisory board was made aware of both the hedging strategy and the resulting losses. By that time, these losses had reached DM 800 million and further losses of at least DM 1.5 billion were expected. Metallgesellschaft’s 1993 pretax loss, estimated at DM 347 million at the end of November 1993, was revised upward to a loss of DM 1.9 billion in January 1994, when a DM 3.4 billion rescue package of equity injections and debt/equity swaps was agreed with its creditor banks.

1 Global Derivatives Study Group (1993).

Derivatives: Recent Supervisory and Regulatory Initiatives

Over the past year, the total notional value of OTC and exchange-traded derivative products has grown by 47 percent to exceed $12 trillion (about twice U.S. nominal GDP). It is well recognized both by the industry itself and by central banks and other supervisory agencies that the continued stability of the derivative markets can only be sustained if the implementation of “best practices” in risk management is accelerated and if continued progress is made toward reducing the sources of systemic risk.19 An important initiative has been the extension of the Basle Capital Accord to include, inter alia, a more comprehensive treatment of the market risk of derivative positions. This parallels the adoption by the European Community (EC) of a new Capital Adequacy Directive (CAD) in March 1993 to modify and extend the 1989 Solvency Ratio and Own Funds Directives, which are similar to the 1988 Basle accord.20 In addition, efforts have been made to improve disclosure and accounting standards, as well as to strengthen the settlement and payments infrastructure in money markets.

Although the 1988 Basle accord covered credit risk for both on- and off-balance sheet positions, its focus on credit risk was increasingly viewed by supervisors as too narrow.21 Market risk—especially, interest and exchange rate risk—has tended to become more important as the trading books of banks have increased in size relative to loan books.22 In addition, some derivative positions, such as currency forward contracts or interest rate swaps, initially do not have a credit exposure; instead, potential credit exposure evolves as exchange rates and interest rates change over the duration of the contract.23 In an effort to deal with these limitations of the 1988 accord, the Basle Committee on Banking Supervision proposed, in April 1993, a new set of capital requirements for banks, which are largely similar to the capital standards under the European Union’s (EU’s) CAD.24 The proposals—featuring capital requirements for market risk, measurement of interest rate risk, and a recognition of netting—are now being considered by national supervisors and by the banking industry.

The main innovations in the 1993 proposals are the separation of banks’ loan and trading books, the isolation of market risk from specific risk, the adoption of a portfolio perspective, and the conversion of fixed-income derivative positions into combinations of simple debt securities for purposes of computing capital requirements.

The loan book continues to be treated as specified in the 1988 accord, while risk in the trading book (including derivative trading) is separated into specific and general market risk. The specific risk of a position includes credit risk, settlement risk, liquidity risk, and the risk of adverse movements in specific securities that are unrelated to market-wide factors (such as the general price level, the exchange rate, or the whole term structure of interest rates). The portfolio approach was adopted because the market risks of different securities are related; this approach permits offsets for positions that are negatively correlated. The so-called building block approach embodied in the new proposals computes total capital requirements as the sum of a specific risk charge and a general market risk charge.

The general market risk applicable to all debt securities (including the decomposed derivative positions) is the risk of unexpected interest rate changes. The Basle Committee has proposed a simplified “ladder approach” to measuring such risk. Fixed income instruments are divided into 13 maturity bands, and instruments within the same maturity band are treated alike. Net unhedged positions are computed for each maturity band, and then capital charges are applied. The Committee also adopted a shorthand method for computing foreign exchange risk. A net overall position is computed for each currency, and all net long currency positions are then added together; the same procedure is applied to all net short positions. The overall foreign exchange position is defined as the greater of the total long position and the total short position. A capital charge of 8 percent is then applied to the overall forex position.25 The Basle Committee is also proposing to allow banks to reduce credit exposures through bilateral netting, as long as such netting meets existing laws and complies with the minimum standards set out in the 1990 Lamfalussy report.26

The industry’s response to the capital proposals has been mixed. Banks in the United States, Canada, France, and United Kingdom—increasingly joined by their supervisors—have argued that the new proposals fail to recognize banks’ effort in exploiting more complicated risk-reducing correlations among their on- and off-balance sheet positions. Indeed, they maintain by making the “least common denominator” the industry standard, the new Basle proposals reduce incentives for banks to adopt more advanced risk management systems. They certainly do not want to maintain two risk-reporting systems. Further, as more and more of the assets of banks become tradable, the distinction between a loan book and a trading book could become increasingly artificial. Major money center banks in the United States have therefore proposed that they be allowed to use their own proprietary risk-management models to come up with prudential capital charges for derivative positions. This would require bank supervisors to evaluate the key assumptions contained in these proprietary risk-management models (particularly those related to the choice of pricing models, the length of estimation periods for obtaining volatility parameters, and the estimated holding periods). Banks in other industrial countries seem somewhat more favorably inclined to the Basle proposals. They do not want the best to become the enemy of the good. They regard the Basle proposals as practical, and as providing a decent approximation to true portfolio risk; in some cases, the Basle proposals are close to the kind of risk management systems they employ on their own behalf. While it is too early to tell, perhaps a compromise on market risk will emerge under which banks would be able to choose between the off-the-rack Basle method and their own custom-tailored models. It is not yet clear which of the two approaches would yield higher capital requirements on average.

The new Basle proposals apply to banks only, and not to securities houses. This is not a problem in EU countries where most securities house functions are performed by banks. However, in the United States and Japan, the lack of harmonization of capital requirements may lead to discrepancies between capital standards for banks and securities houses. Given that many of the distinctions between banks and securities houses are quickly disappearing, more uniform standards are called for. To unify standards, the International Organization of Securities Commissions has devoted substantial efforts to setting up global capital standards, but serious disagreements between securities supervisors remain, primarily over the appropriate capital charges for equity trading books. However, most market participants did not expect a failure to reach agreement on uniform capital standards to result in large changes in market shares between banks and securities houses, or between countries.

In addition to extending capital requirements, efforts are under way to improve disclosure and accounting standards and to strengthen market infrastructure. Supervisors have encouraged banks to provide more detailed accounts of their derivative operations. Banks appear to see greater disclosure as largely in their own long-term interest, and in any case, as probably inevitable—but worry that (unless implemented on a universal basis) it could aggravate differences in national accounting procedures and further disadvantage them relative to some nonbanks. U.S. bank regulators have proposed that banks disclose their income from derivative operations, as well as the level of their counterparty risk. One strong motivation for greater disclosure is that the present lack of transparency of consolidated positions in the derivative markets increases the likelihood of precautionary runs based on faulty information; that is, market participants may test the solvency of a bank when they suspect that it is having problems in its trading book. The better the information available to market participants, the better the chances of pricing risk appropriately and of avoiding instabilities induced by rumors. The issue of disclosure and the marking-to-market of off-balance sheet positions is currently under study at the Bank for International Settlements, and it has found support within the Financial Accounting Standards Board and the Group of Thirty.

As desirable as stricter disclosure standards for derivatives are, it needs to be acknowledged that thorny questions remain about what to disclose, how often to disclose, and to whom to disclose. Should, for example, disclosure cover only notional or marked-to-market exposure, income from derivative operations, and the level of counterparty risk—or should the institution go further and provide information on the maximum loss that it would be prepared to sustain in its trading activities under adverse market conditions, and on what measures have been put in place to ensure that this loss limit is respected? Is it adequate to describe the institution’s risk management strategy for derivatives in broad qualitative terms or does this strategy need to include specific quantitative information (e.g., capital at risk)? Since derivative positions can change rapidly during a short time period—unlike a bank’s loan book—the frequency of disclosure is likewise a very relevant issue. A marked-to-market statement that is three months old may not provide an accurate guide to what the institution’s exposure is today. Should this timing problem be handled by more frequent disclosure or instead by providing the maximum and minimum exposure during a given period? How much information should be made available to the public, and how much should only go to the regulators? If the concern is about runs based on misinformation, then priority ought to be given to public disclosure. Alternatively, if the emphasis is on detecting problems at an early stage—while safeguarding proprietary material, the tilt might be toward timely disclosure to supervisory authorities. On the whole, it seems that the authorities are concentrating much of their effort—and appropriately—on evaluating the quality of risk management in banking institutions, rather than on trying to track and to assess exposure on a day-to-day basis.

The growth of derivative markets has also added significantly to the strains on the infrastructure of financial markets, particularly wholesale payments systems.27 The rising volume of intraday credit exposures generated in end-of-day net-settlement payments systems and the moral hazard such systems create have been important considerations for moving to real time gross settlement (RTGS) systems. RTGS provides immediate finality of payments and thereby reduces settlement risk. Moreover RTGS provides a basis for achieving delivery versus payment in securities settlement. By 1996 all but two EU members will have RTGS for domestic payments. In particular, Belgium, France, Ireland, and Italy will replace their existing net payments systems, and, in the United Kingdom, the Clearing House Association Payments System (CHAPS) will be modified to provide RTGS in 1995.28

The U.S. Federal Reserve has also set up a fee structure for daylight overdrafts that is currently being implemented. It is expected that this measure will, inter alia, increase netting and thereby reduce systemic risk, as the volume of credit generated in the net payment system declines.

In order to reduce the systemic risk associated with the pyramiding of gross transaction volumes created by derivative and other money market transactions, some authorities are studying the feasibility of adopting a clearinghouse structure for netting and for settling some of the more standardized OTC derivatives. The model would be similar to mechanisms that already exist on futures exchanges. One such clearinghouse—the Delta Government Options Corporation—already clears OTC options written on U.S. Treasury securities. A derivative clearinghouse would become a counterparty itself between the two contracting parties; it would monitor the value of each side of the contract and see to it that margin accounts are maintained. Support for such a clearinghouse in the banking community may however still be some time in coming, given the large costs required to set up new institutions, the loss in market power of AAA-rated dealers, and the narrow range of contracts that could be covered.29

Role of the Central Bank in Banking Supervision

A few years ago, when the statutes for a future European central bank were being formulated, a contentious issue was the role, if any, that this new central bank should play in the supervision of banks.30 This question could not be resolved by reference to the practices of national central banks within the (then) European Community since those practices differed; for example, the Bank of England and the Bank of France had substantial formal responsibilities in the banking supervision area, whereas the Bundesbank did not. During this past year, this same issue surfaced on the other side of the Atlantic. Specifically, the new U.S. administration proposed that the responsibility for supervision of banks and savings and loans (now shared among the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Federal Reserve, and the Office of Thrift Supervision (OTS)) be streamlined by replacing the four supervisory authorities with a single federal banking supervisor. The Federal Reserve System opposed that proposal, arguing that it is important as a matter of public policy for the Federal Reserve to maintain a hands-on involvement in bank supervision.31 Meanwhile, in the Pacific, the Reserve Bank of New Zealand has taken the position that supervision of banks should lean more heavily on market forces, with a reduced role for the central bank or any other authority.32

Those who favor making the central bank the lead supervisor of banks maintain that (i) the central bank’s role in resolving financial crises makes it imperative for it to have a close and continuous knowledge of the position and workings of banks-knowledge that can only be gained by hands-on supervision; (ii) when the central bank has close proximity to markets and to banks, there are important synergies for the formulation of monetary policy because the central bank will be more sensitive to key financial sector developments (e.g., the Federal Reserve has argued that its supervisory role helped it to be more sensitive to the “credit crunch” in 1991/92); and (iii) the central bank’s supervisory role makes it easier for the central bank to get information from banks.

Proponents of this view note that fundamental and ongoing changes in the financial system—the growth of short-term money markets (interbank repurchases, negotiable bank liabilities, commercial paper, treasury bills, derivatives, and money market mutual funds), the ascendancy of quote-driven, dealer-based securities markets, and the spread of arbitrage-driven portfolio management (including dynamic hedging)—require that the relevant markets remain liquid under adverse circumstances. In order to manage liquidity shocks—which will arise from time to time under even the best monetary management—the central bank needs hands-on, up-to-date knowledge of the working of the financial system, of the linkages among financial institutions, of the exposures of institutions and of the quality of their balance sheets, and of the right personnel to contact at times of emergency; it also is necessary to have close ties with other central banks to facilitate the flow of information. It is argued that without this knowledge and these contacts, the central bank will find it more difficult to distinguish illiquidity from insolvency, and to determine in real time the most appropriate form of intervention.

The opposition to placing banking supervision in the central bank emphasizes that (i) the central bank can get the information it needs about the health of both the banking industry and of individual banks from the banking supervisor (e.g., both the Bank of Canada and the Bundesbank—neither of which has responsibility for bank supervision—report that they receive adequate information for their needs); (ii) the central bank can get its views on bank regulation heard (e.g., in an interagency council) without being the formal supervisor of banks; (iii) a lead role in supervision might induce the central bank to pull its punches (for financial fragility reasons) in the implementation of monetary policy; (iv) the need to close banks often involves an element of expropriation of private property, which is best left to a democratically elected body; and (v) banking supervision inevitably takes too much time away from what should be the main task of the central bank, namely, the design and implementation of monetary policy.

Moving farther on the spectrum toward less involvement by the central bank in banking supervision, we have the market approach proposed by the Reserve Bank of New Zealand. Here, regulatory constraints on banks would be reduced—though not eliminated—in favor of public disclosure and market discipline. Prudential requirements (e.g., large exposure limits and limits on open currency positions) would be abolished, with the exception of capital standards. There would be increased emphasis on the role of bank directors in taking responsibility for the sound management of their banks. Each bank would be required to display prominently a credit rating on its premises if it has a rating; if not it must disclose this fact. Public disclosure requirements (relating to risk concentration and capital) would be increased, and the infrastructure of the financial system would be strengthened (by moving to a RTGS system for wholesale payments), so as to reduce the systemic consequences of a bank failure.

Supervision of Nonbanks

Who should supervise banks? Interesting as that question is, it can legitimately be seen as only one part of the broader and logically prior issue of how best to supervise and to regulate the entire financial services industry in the industrial countries. While a full treatment of that issue would go beyond the manageable scope of this study, there is one aspect of it that emerges as particularly relevant for this year’s report, namely, whether the traditional separation in some major industrial countries between the supervisory approach to banks and that toward nonbanks remains appropriate.

Those who wonder about the traditional approach make the following argument. The muscle in financial markets in many industrial countries is increasingly being provided by institutional investors (mutual funds, pension funds, insurance companies, and hedge funds) and by securities houses—not by banks (see Box 2 for a discussion of mutual funds). Merrill Lynch, the world’s largest broker-dealer, now has approximately $500 billion in client assets, and Fidelity Investments, the largest mutual fund, has about $300 billion under management. In the United States, the share of credit assets intermediated by commercial banks has fallen from about 60 percent at the end of World War II to slightly over 20 percent today. Meanwhile, the lines of demarcation that once separated the activities of banks from those of nonbanks have become increasingly blurred.

Box 2Developments in Mutual Fund Investments

Investment in mutual funds has grown rapidly in recent years, particularly in the United States. This growth in mutual funds has generally been at the expense of bank deposits, as households searched for yields higher than those offered by banks.

The term “mutual fund” refers in the United States to regulated funds that invest in a wide variety of financial instruments. Many of these funds are open-end, in that investors can withdraw their funds at any time directly from the fund.1 Mutual funds differ widely according to their investment strategy, but they may be divided into two large groups. One group consists of funds that invest in longer-term assets, especially stocks and bonds. The other group consists of funds, known as money market funds, that invest in short-dated money market instruments, including certificates of deposit, commercial paper, and Treasury bills. Mutual funds are tightly regulated in the United States, under the authority of the Securities and Exchange Commission (SEC). The chief governing statute is the Investment Company Act of 1940. This act allows funds to avoid some forms of taxation and permits public marketing, but imposes restrictions on leverage.

In 1993—for the third consecutive year—there were massive net inflows into mutual funds in the United States. About $280 billion flowed into U.S. nonmoney market mutual funds in 1993, compared with inflows of $200 billion in 1992 and $121 billion in 1991; such inflows had averaged only $41 billion in each of the previous four years. From 1990 to 1993, the assets of these funds grew at an annual average rate of 38 percent (from $569 billion at the end of 1990 to $1.10 trillion at the end of 1992 and to $1.51 trillion at the end of 1993). Such growth is not unprecedented, however. Mutual fund assets expanded at an annual average rate of 50 percent between 1981 and 1986.2

With the market turbulence of February and March 1994, net inflows into nonmoney market mutual funds fell sharply. After a $37 billion inflow in January (and an average of $24 billion a month in 1993), inflows fell to $22 billion in February and $14 billion in March–the lowest monthly inflow in a year and a half.3

Over the last three years, mutual funds have expanded their share of U.S. financial assets. The ratio of fund assets (excluding money market funds) to savings and small time deposits in banks grew from 21 percent in 1986 to 65 percent at the end of 1993.4 There has thus been a considerable shift from bank deposits into mutual funds as a component of personal savings. U.S. banks are becoming increasingly involved in the mutual fund business. There is a trend toward bank sales of mutual funds, and some banks have also taken steps to acquire mutual fund managers. Most notably, Mellon Bank has recently been given approval to purchase Dreyfus, which manages funds holding $80 billion in assets.

The growth of mutual fund assets in other major industrial countries appears less pronounced than in the United States. For these countries, data are available only through 1992.5 They show that the growth of U.S. funds outpaced those of the other countries. Annual rates of growth during 1990–92 for open-end investment companies in the other five major industrial countries range from a high of 13 percent in Italy to a contraction of 5 percent in Japan.6 Growth of funds’ assets in the United States was 22 percent over the same period, and more if money market funds are excluded.7

1 Closed-end funds differ in that shares cannot be redeemed, but investors instead can sell their shares on the secondary market.2 Investment Company Institute.3 Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, various issues, Table 1.47.4 Board of Governors of the Federal Reserve System (1994), Table 1.60.5 A consistent data series is not available for Canada.6 Funds in Luxembourg expanded at a 28 percent rate during this period.7 These data are from Investment Company Institute (1993). See Goldstein, Folkerts-Landau, and others (1992) for a discussion of longer-term trends and of regulations governing mutual funds in Europe and Japan.

More and more, these institutions are offering similar products to the same customers. In some cases, by looking at the balance sheets, list of activities, and funding sources of large wholesale institutions, one would be hard pressed to tell which ones were “banks” and which ones were “securities houses.” Moreover, the activities of large financial institutions—be they banks or nonbanks—are progressively becoming more “international” in character.

Yet the regulatory structure in much of the industrial world is segmented in a way that does not recognize these growing similarities and trends. Not only are regulatory lines drawn according to the type of provider of a financial service—and not to the type of service provided—but the attention to macro-prudential considerations is very different. On the bank side, considerable resources are being devoted to the supervision of banks. Bank supervisors have the authority to obtain at short notice—if they do not already possess it—any information on banking activities that they deem necessary to fulfill their responsibilities. They can issue cease-and-desist orders, and they can use moral suasion to influence what banks do and how they do it. Important strides have also been made in achieving international coordination and harmonization of supervisory practices. The Basle accord on capital standards and the existing agreements on the sharing of information among home and host country supervisors are outstanding examples of this process. Banking supervisors of the Group of Ten meet monthly in Basle to discuss current developments of mutual interest, including the identification of any potential systemic threats. The emphasis is on the safety and soundness of individual institutions, and on limiting systemic risk. In contrast, the supervisory framework for nonbanks is oriented toward investor protection and market integrity. Disclosure of financial positions and exposures tend to be more limited than in the case of banks. There is some degree of international sharing of information through memoranda of understanding, and some efforts at international harmonization of capital standards and the like under the auspices of the International Organization of Securities Commissions—but less so than for banks. There is no international group of nonbank supervisors that meets frequently to review developments in markets and to identify at an early stage potential sources of systemic risk.

Concerns about the adequacy of the existing approach to supervision of nonbanks fall into three categories. First, there is a worry that failure of some kinds of nonbanks, say, a large securities house, would have adverse spillover effects on other financial institutions and players that would not be much less serious than those associated with failure of a large bank. Underlining this concern is the thought that banks are less “unique” relative to nonbanks than they used to be.33 Second, even if it were still true that it would be considerably easier to wind down a group of large, troubled nonbanks (say, mutual funds) because of the higher marketability of their assets, there is the concern that large-scale redemptions could initiate large, abrupt asset price swings that would in turn cause difficulties for risk-management at other institutions (where the assumption for dynamic hedging and other risk management practices is that asset prices will not be subject to large gaps or jumps). The difficulties experienced by equity brokers at the time of the 1987 stock market crash is a dramatic case in point. Third, the segmented structure of regulation may well impede the efficient delivery of financial services and retard the competitiveness of those providers that face a relatively high burden of regulation.

Suggestions for altering the current supervisory framework for nonbanks fall into two camps. One would be to extend some of the safety and soundness and macro-prudential considerations that now apply to banks to particular classes of nonbanks. The other, much more ambitious way to go is to redraw the regulatory map by moving toward functional regulation.34 Under this approach, banks and nonbanks alike would be free to provide either a wide range or narrow subset of financial services, depending on their comparative advantage. For each type of functional activity (e.g., derivatives trading, banking, insurance) market participants would develop codes of conduct and other elements of self-regulation; these codes of conduct would be different for retail business (small investors) than for wholesale business (large, professional firms). Supervisory authorities would conduct market surveillance in an effort to uncover wrongdoing. Firms with higher capital and better risk management systems would be subject to less oversight than those with weaker internal lines of defense—but there would not be regulatory distinctions by legal classes of financial institutions.35

Enough to say that there are many who doubt the need for such a different approach to the supervision of nonbanks. They emphasize that (i) thus far, there is precious little evidence that winding down troubled nonbanks has created adverse systemic effects—suggesting that differences between banks and nonbanks are still important; (ii) where liquidity problems at certain kinds of nonbanks (large securities houses) threaten to induce systemic concerns, these institutions can be given access to the central bank’s discount window (as already implemented in the United States); (iii) these potential problems with nonbanks are much less serious in countries where universal banks carry out banking, securities, and insurance activities under one roof; (iv) information sharing and international coordination among nonbank supervisors has recently expanded substantially; (v) adding new prudential requirements for nonbanks will only shift risky activities to other, less-regulated institutions and locations—leaving systemic risk unaffected and reducing the international competitiveness of regulated nonbanks in the process; and (vi) functional regulation will create its own inefficient patchwork of regulatory burdens, particularly for financial firms that engage in many functions.

A number of other issues—including the resolution of banking problems in some industrial countries—are considered in Annexes II and III.

A compendium of best practices in risk management for derivatives is contained in the report by the Global Derivatives Study Group (1993). Central banks and other supervisory agencies in some of the major industrial countries have recently issued extensive reports on developments in derivatives markets, with particular emphasis on sources of systemic risk.

For a more detailed discussion of the EC directives, see Goldstein, Folkerts-Landau, and others (1993b), Section V.

Credit risk is the risk of counterparty default.

Market risk is the possibility of losses stemming from asset price changes that are unrelated to changes in the credit standing of any particular counterparty.

Banks are not exposed to credit risk for the full face value of these contracts, but only to the cost of replacing the cash flow if a counterparty defaults.

The 1993 Basle proposal and the CAD follow the same approach in the measurement of interest rate risk and the same building block approach in aggregating market and specific risk. But the Basle proposal is more stringent than the CAD in the treatment of foreign exchange risk and equity risk.

A simple numerical example may be helpful in understanding how capital charges for market risk are computed. Suppose a bank has a long position in deutsche mark of $50 million and a long position in sterling of $30 million. The total long position in foreign exchange is then $80 million. Likewise, assume that the bank has a short position in yen equal to $40 million; the total short position in foreign exchange is then the same $40 million. The overall foreign exchange position—the greater of the long and short positions—would be $80 million, and the capital charge would be 8 percent of this overall position, or $6.4 million. Capital charges for equity and traded debt portfolios are arrived at in a similar manner. In the case of equity, positions in individual stocks replace positions in currency, whereas for traded debt, aggregated positions in each maturity class replace positions in currency. The 8 percent capital charge for foreign exchange positions is to be added to the capital required to cover the credit risk on the same items, whereas the capital charge for debt securities and equities is substituted for the capital charge required by the 1988 accord to cover credit risk.

This was also the subject of the International Symposium on Banking and Payment Services organized by the U.S. Federal Reserve Board in Washington on March 10–11, 1994.

While there is a general consensus in favor of RTGS, there is no such consensus with respect to cross-border payments. Some argue that such risk could be eliminated by extending the hours of operation of domestic RTGS systems to provide RTGS and delivery versus payment for cross-border payments, and the recently announced decision to increase the hours of operation of Fedwire is designed to increase the overlap of the Japanese and United States settlement periods. Others favor the netting of cross-border multicurrency payments. Direct links between national RTGS payments systems could easily result in the transmission of liquidity disturbances across borders.

A potentially more successful proposal is the introduction of a derivatives collateral manager who would be a neutral third party to a bilateral collateral agreement, but who would not assume responsibility for contract performance as the derivatives clearinghouse would.

The Federal Reserve has proposed that the four agencies be consolidated into two, through the merger of the OCC and OTS into the Federal Banking Commission. Moreover, the Federal Reserve suggests that the FDIC be removed from examining healthy institutions and that all independent state-chartered banks and all lead state-chartered banks in holding companies be put under the supervision of the Federal Reserve. The Federal Reserve would also retain supervisory jurisdiction over large holding companies. See Greenspan (1994).

Some countries—for example, Argentina, Costa Rica, Finland, Lebanon, and Uruguay—have opted for yet another approach, in which banking supervision is elevated to semi-independent status within the central bank.

The uniqueness of banks is usually attributed to their joint provision of liquid liabilities and of nonmarketable, illiquid business loans.

See McDonough (1994) and Miller (1993).

The U.K. authorities have probably gone farthest in implementing a functional approach to regulation.

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