Abstract

The Federal Reserve, together with the other federal banking agencies, has been working for some time on an approach to assessing capital adequacy that takes into account differences in risk profiles among banking organizations. Early last year, U.S. supervisory authorities and the Bank of England jointly issued for comment a risk-based capital proposal applicable to all U.S. and U.K. banking organizations. Action on this proposal was deferred in an effort to enlist the participation of a larger number of countries in the development of a more broadly based international framework.

The Federal Reserve, together with the other federal banking agencies, has been working for some time on an approach to assessing capital adequacy that takes into account differences in risk profiles among banking organizations. Early last year, U.S. supervisory authorities and the Bank of England jointly issued for comment a risk-based capital proposal applicable to all U.S. and U.K. banking organizations. Action on this proposal was deferred in an effort to enlist the participation of a larger number of countries in the development of a more broadly based international framework.

An important measure of progress toward this goal was achieved last December when the central bank governors from the Group of Ten industrial countries endorsed a proposed framework developed jointly by the regulatory authorities represented on the Basle Committee on Banking Supervision. 1 This proposal, which supersedes the earlier U.S./U.K. measure, is currently being reviewed, or has been published for public comment, in each of the Group of Ten countries. Both the international framework and the implementing guidelines being proposed by the U.S. banking authorities incorporate many of the public comments received in response to prior proposals on risk-based capital—although additional comments and important issues will have to be carefully considered and discussed internationally before a final standard can be adopted. It is our hope and expectation that the framework, with whatever modifications and refinements are deemed necessary, will be put into place by most or all of the major industrial countries by the end of this year (1988) or early next year.

The Federal Reserve Board has long believed that capital adequacy is a particularly important factor in promoting the soundness of individual banking organizations, as well as the health and stability of the banking and financial system. For this reason, we have implemented policies and procedures over the years—both in connection with on-site examinations and in the review of regulatory applications—designed to encourage institutions to strengthen their capital positions when necessary. The risk-based capital proposal therefore represents a continuation of our ongoing efforts to ensure that banks are adequately capitalized and that our supervisory policies are responsive to changing practices and trends within the banking system.

Equally important, however, is the element of international cooperation that lies at the heart of this proposal. Indeed, development of the risk-based framework in conjunction with central bank and supervisory authorities from the major industrial countries represents a significant cooperative step toward greater harmonization of important supervisory standards among nations with major financial centers. This is particularly important in view of the growing internationalization of banking and financial markets. The risk-based capital proposal underscores the interest that supervisors from the leading industrial countries share in fostering a stable and resilient international banking system and in reducing sources of competitive inequality for international banking organizations stemming from differences in national supervisory requirements.

Before addressing the risk-based capital proposal and related issues in greater detail, I would like to make some general observations about the Federal Reserve’s supervisory policies on capital adequacy and why we believe movement to a risk-based standard is particularly important and timely.

I. Background

As I have indicated, the Federal Reserve Board has long viewed adequate capital as a critical determinant of the health of our nation’s banking institutions—a view that I know is shared by many members of Congress. The capital ratios of some of our larger banking organizations declined throughout most of the period extending from the early 1970s and the early 1980s. This was due, in part, to the rapid growth in their assets, including their overseas loans; the effects of intensified foreign and domestic competition on profit margins; and the adverse impact of inflation on bank balance sheets. These developments, as well as increasing concern about the risks borne by banks both domestically and internationally, led the Federal Reserve and the other federal banking agencies to establish formal supervisory standards specifying minimum acceptable levels of bank capital.

These standards, stated in terms of the ratio of primary capital (equity plus loan-loss reserves and mandatory convertible debt securities) to total assets, were designed to establish a floor below which a banking organization’s capital would not, under normal circumstances, be allowed to fall. In adopting these guidelines, the Federal Reserve indicated that it would modify its examination and regulatory policies to encourage organizations that did not meet the minimums to strengthen their capital bases over time. In our view, this program has achieved an important measure of success—the average ratio of primary capital (net of intangible assets) to total assets for the 50 largest U.S. banking organizations has risen from well below 5 percent at the end of 1981 to over 7 percent today.

The difficulties and challenges facing banking organizations, however, also increased during this period. Since the beginning of this decade, our banking system has been confronted with asset-quality problems relating to the energy, agriculture, real estate, and export sectors of our economy and to a deterioration in the condition of some developing country borrowers. These conditions have led to a significant increase in a number of problem institutions and record numbers of bank failures. While all of this has been happening, the environment in which banks operate has also been undergoing rapid change. Banking organizations today must cope with greater volatility in financial markets; intensified competition from both domestic and foreign banks, as well as nonbank financial institutions; the increasing size, complexity, and speed of financial transactions; accelerating financial and technological innovation; the rapid growth and widespread use of off-balance-sheet financing techniques; and an existing legal framework that hampers U.S. banking organizations in their efforts to compete effectively in the provision of important financial services.

The pressures facing many banking organizations and the conditions I have just described underscore the importance of strengthening capital ratios and suggest that the increase in primary capital to which I have alluded does not, by itself, give a complete picture of the capital adequacy of our nation’s commercial banking organizations. For example, our traditional ratios of primary capital to total assets do not take explicit account of the growth of off-balance-sheet items; nor do they recognize differences in the level of risk among broad categories of bank assets. Moreover, primary capital includes certain convertible debt instruments and loan-loss reserves whose relative roles in primary capital have changed as a result of heavy loan-loss provisions relating to developing country exposure and other asset-quality problems. At the same time, there has been a decline in stockholders’ equity in many of our larger institutions; in some cases, ratios of common equity to total assets have fallen below 4 percent—roughly where they stood in the late 1970s and early 1980s.

Taken together, these developments suggest the need for a measure of capital adequacy that is more sensitive to broad differences among banks in the degree of risk associated with their assets, including off-balance-sheet exposures, and that addresses the changes that have been taking place in the composition and quality of bank capital.

Another major factor in the development of an international risk-based capital framework is the growing globalization of banking and financial markets. Over the last decade or more, U.S. banking organizations have increasingly found themselves in direct competition—both in this country and abroad—with major banking organizations from other countries. Moreover, technological advances and deregulation have resulted in increasingly complex financial linkages and trading relationships among the world’s major financial centers. Given these developments, we simply cannot ignore the impact of differing regulatory standards on U.S. banks’ ability to compete globally. More consistent supervisory standards among countries can contribute to greater competitive equality and, in the long run, to a safer and more stable international banking system.

Congress, too, had indicated its recognition of this situation by passing the International Lending Supervision Act of 1983. One of the major goals of this legislation was to strengthen the bank regulatory framework by encouraging greater coordination among regulatory authorities in different countries. In this regard, the Act instructed U.S. banking authorities to work with governments, central banks, and regulatory authorities of other major countries in an effort to maintain and, where necessary, strengthen the capital positions of banking organizations involved in international lending. The active role played by U.S. regulators in formulating the international proposal represents an important step in carrying out this congressional mandate.

II. Risk-Based Capital Framework

I would now like to summarize the major elements of the risk-based capital proposal and some of the issues relating to its implementation by the Federal Reserve.

Briefly stated, the risk-based capital framework comprises the following four elements:

(1) A consistent international definition of core, or common, equity capital and a “menu” of recognized non-common-equity components that, at the discretion of the national supervisor, can supplement the equity capital base.

(2) A framework for relating capital requirements, in a more systematic fashion, to broad risk considerations, including risks associated with off-balance-sheet activities.

(3) A schedule for achieving a minimum ratio of total capital to weighted risk assets of 7.25 percent by 1990—of which at least 3.25 percentage points should be in the form of common stockholders’ equity—and 8.0 percent by 1992—of which at least 4.0 percentage points should be in the form of common stock.

(4) Transitional arrangements designed to provide a reasonable amount of time for organizations to bring their positions into conformity with the risk-based framework.

Proposed guidelines for implementing this framework for U.S. banking organizations have been issued for public comment, and I can assure you that the Federal Reserve will, as in the past, carefully consider these comments before continuing our international discussions on the final shape of the risk-based capital framework.

Time does not permit me to address the risk-based capital proposal in detail; however, there are a number of important general observations I would like to make concerning the development and implementation of the standard.

Perhaps more significant than any specific provision or detail of the proposal is its recognition of the importance of international cooperation in achieving key supervisory goals. These goals are to encourage banking organizations, in particular large international institutions, to strengthen their capital positions where necessary and to reduce sources of competitive inequality arising from significant differences in national supervisory requirements. We believe the development of the risk-based capital framework has contributed importantly not only to the realization of these goals but also to strengthening and broadening the process of international cooperation itself—a point that is particularly important in light of the increasing financial volatility and the growing internationalization of banking and financial markets.

The risk-based capital proposal is, in some respects, quite complex—indeed, development of the framework required judgments and compromises on a number of complicated supervisory issues and difficult decisions at the margin. Nonetheless, we believe that implementation of the risk-based capital framework will improve our existing capital policies in two important respects.

  • First, the framework will require that any significant credit risks associated with off-balance-sheet items—including many of the more recent and innovative financial instruments, as well as more traditional contingencies and guarantees—be subject to minimum capital requirements.

  • Second, the framework removes disincentives to holding liquid, low-risk assets by explicitly recognizing that assets such as cash, government securities, and liquid interbank claims require less capital support than standard commercial loans. This is done by assigning assets and off-balance-sheet exposures to one of five risk categories based upon broad distinctions in relative credit riskiness. Unlike our current ratios, which treat all assets alike, the risk-based framework will apply lower risk weights and, therefore, will establish lower capital requirements for those assets that involve less-than-normal credit risks.

While reasonable people may differ on certain details of the proposal, we believe that explicit recognition of off-balance-sheet exposures and differences in credit risk among major categories of assets will give clearer and more rational supervisory signals indicating recognition of the need to support risk-taking with adequate capital.

The risk-based capital proposal also addresses the issue of the composition of capital. In doing this, the proposal emphasizes the importance of a strong base of common stockholders’ equity—requiring that, after the transition period, it constitute at least one half of a bank’s total capital—while taking appropriate account, subject to certain limitations, for the strength provided by other (supplementary) elements of bank capital, such as preferred stock, subordinated debt, and loan-loss reserves. The important role played by common equity capital reflects the fact that this component is both freely available to absorb unanticipated losses and provides maximum strength and flexibility to an organization when it is experiencing losses or other financial pressures.

The determination of what constitutes an “adequate” level of capital for a banking organization obviously entails making a difficult judgment that requires one to consider a number of complex factors. The major function of capital, of course, is to absorb unanticipated losses, thereby lessening the probability of bank failures and thus minimizing the attendant economic and social costs. In this regard, we believe that the equity and total capital standards incorporated in the risk-based capital framework should be viewed as minimums. Our experience suggests that banking organizations should endeavor to operate above these minimum standards if they are to maintain a critical margin of safety during periods of financial strain or prolonged adversity. Indeed, banking organizations with strong capital bases are better positioned to withstand financial shocks, including large losses, and, other things being equal, have more time to resolve their asset or earnings problems than those organizations with thin or marginal capital positions.

In general, the overwhelming majority of community and regional banking organizations will have little difficulty meeting the standards incorporated in the risk-based capital proposal. For those organizations, including some large institutions, that will have to raise additional capital, the transitional arrangements and phase-in period should provide them with a reasonable amount of time to bring their capital bases into compliance with the minimum risk-based standards.

Another point I would like to address relates to the manner in which the Federal Reserve Board is proposing to apply the risk-based capital ratio. The international proposal has been designed to address the activities of international banking organizations and those institutions engaged in off-balance-sheet activities, although national supervisory authorities would have the latitude to apply the framework more broadly to banks under their jurisdiction. Because the fundamental principle of relating capital needs to risk considerations has wide applicability, we are proposing to employ the general framework in evaluating the capital adequacy of all U.S. banking organizations, regardless of size—although we intend to minimize any unnecessary burden or disruption the framework could entail, particularly for small institutions.

In accord with reasonable and prudent transitional arrangements, we also intend to apply the framework to the analysis of the capital positions of foreign banks seeking to make acquisitions in the United States. This is consistent with our nation’s policy of national treatment, in that it requires that foreign banks operating in this country be held to essentially the same standards of financial strength and soundness as domestic institutions.

While the risk-based capital proposal establishes a broadly consistent framework for use in the leading industrial countries, it does not mandate rigid uniformity among countries. Instead, the proposal provides a degree of flexibility to national supervisory authorities to accommodate certain differences among countries in accounting conventions, in the structure and evolution of banking and financial markets, and in supervisory techniques and methodologies. Moreover, the proposal acknowledges that the evaluation of capital ratios is but one step in the overall assessment of capital adequacy. Any final judgment about an organization’s capital position must take account of many other important factors that are not included in the risk-based capital calculation. These include the level and severity of an organization’s problem assets, its liquidity, its exposure to interest rate movements, the level and trend of its earnings, and the quality of its internal systems and controls.

Ultimately, of course, no single index or ratio can, by itself, capture all of the critical factors that go into the assessment of capital adequacy. We believe, however, that by emphasizing the importance of a minimum base of equity capital and by making the assessment of capital needs more systematically sensitive to risk considerations, including the risks associated with off-balance-sheet activities, the risk-based capital framework will foster a significant strengthening of our supervisory policies for assessing capital adequacy. Certainly development of the framework underscores the critical role of capital in helping banking organizations withstand financial stress and weather prolonged periods of economic adversity—a point that is important for both small community or regional banking institutions and large international banking organizations.

In a very important sense, both bank regulators and bankers themselves share a common interest in maintaining an adequate level of bank capital. The maintenance of strong capital positions need not be a burden to a bank nor hamper its efforts to compete. Indeed, banking organizations with strong core capital positions are often effective competitors with good earnings and sound asset portfolios. This is not surprising, since a significant commitment of resources by shareholder/owners gives them a particularly strong incentive to oversee the affairs of their bank. To be sure, strong capital positions may actually give institutions a competitive advantage during periods in which customers, depositors, or investors seek stability and fundamental strength, as well as convenience and high returns. Moreover, strong capital can serve not only as a critical cushion to help banks weather the kinds of pressures they experienced in the 1980s but it can also provide banks with the financial strength to adapt successfully to future changes—changes that we hope and expect will involve additional banking powers and new opportunities to compete more freely in the provision of banking and financial services.

In the end, our banking organizations will be stronger and more competitive, and the international banking system more resistant to financial strains, if bank supervisory authorities from the major industrial countries cooperate in the establishment of consistent and credible standards for the assessment of bank capital adequacy. I believe the risk-based capital proposal constitutes an important and constructive step in this direction.

COMMENT

WILLIAM A. RYBACK

I would like to start off with a few remarks and a few of my own observations on both presentations, then focus on two or three questions that I thought we would all like to think about as a group.

As Mr. Thompson told us, the origins of the Basle Committee were an early recognition, fostered by accidents that happened in banking that had worldwide consequences, of the need for international cooperative efforts on bank supervision. I refer to Bank Herstatt, the Franklin National Bank, the United States National Bank of San Diego, and a number of other accidents that occurred in the 1970s. The Basle Committee has now become fundamental to the supervisory process, both nationally and internationally. Why? Because its members advance the ideas and concepts that are important in everyday bank supervision, as well as exchanging views on various relevant matters. I might add that I personally believe that the success of the Basle Committee should be judged not so much by what it has accomplished but rather by what it may have prevented.

I think that the Concordat, which was originally issued in 1974 and amended in 1983, outlined very well some of the responsibilities that bank supervisors had, but it also did something else. It opened up the subject area for further discussions and cooperative efforts. As Mr. Thompson indicated, it presented members of the Committee with an opportunity to get to know their counterparts and be able to discuss sensitive matters with them. Moreover, in discussing supervisory matters, what you do not say is sometimes as important as what you actually say. When the Concordat was being developed, some observers inquired whether the Committee’s work would be done once the Concordat was finished. This proved not to be the case.

One of the early issues the Committee tackled was capital adequacy. Capital standards are, of course, viewed as an essential means of ensuring competitive equality across borders and promoting stability in the international banking system. The issue of capital adequacy and its measurement had a long gestation period. It was first raised by the Governors of the Bank for International Settlements (BIS) when they instructed the Basle Committee to look at ways to measure and define capital. These efforts were renewed in 1984 and 1986. Significantly, the central concept used in addressing this issue—that is, that pure equity is the cornerstone upon which to build a model—did not change in nine years. Those views were expressed in 1980, in 1984, in 1986, and in December 1987. While we have certainly not finalized our views on capital adequacy, the concept of capital standards has nevertheless been accepted at the Committee level and is supported in principle by the BIS Governors. The Basle capital standard appears to be gaining wider and wider acceptance within the banking community, although some bankers (I am including this here not as a criticism but only as an observation) are still expressing provincial and self-serving views and trying to modify the proposal to suit their individual circumstances.

I think that ongoing efforts in international bank supervision raise three fundamental questions that we might want to consider this afternoon.

One is whether, if one accepts the concept of interdependence of markets and takes international banking as a model, one has to look at a number of issues that beg for some kind of initial convergence of views on an international plane. Two of the issues that I see as critical are the international payments systems and the interconnections between bankers and securities businesses. How these issues should be tackled is, I think, an issue that ought to be discussed in an international context. Second, if one views the convergence of capital standards, as I do, as only a very fundamental step in the internationalization of bank supervision and regulation, it follows that other issues may need to be resolved once capital adequacy has been digested and agreed upon. These other issues may include interest rate risk and the treatment of off-balance-sheet items. These kinds of issues lend themselves to consideration in a broad context. The question that the trend toward global harmonization of bank regulation raises is whether its continuation is possible and desirable. And, finally, the question arises as to how the views of those countries that are not represented on the international bank supervisory committees can be incorporated into the committees’ discussions and decisions. Presently, one may obtain documents from the Basle Committee showing its current thinking on particular issues. Perhaps the Committee should consider going beyond this limited effort to communicate with its constituencies and finding out how a wider body of views might be solicited at an early and fundamental stage of the discussion of particular issues.

*

Testimony substantially in the form of these remarks was submitted as a statement by Mr. Taylor to the Subcommittee on General Oversight and Investigations of the Committee on Banking, Finance and Urban Affairs of the U.S. House of Representatives on April 21, 1988.

The proposal was incorporated into the Report of the Basle Committee on International Convergence of Capital Measurement and Capital Standards, which appears in Appendix II of this volume.