Statement by Richard Spillenkothen.

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

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

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

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

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

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

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

With that background, let me illustrate some of the changes taking place within the industry and the manner in which they are affecting our supervisory practices.

Advances in Risk Management

at Banking Institutions

Advances in computerization and communications, globalization of financial markets, and the resulting competition have all served to develop opportunities, inspire change, and bring about more efficient use of scarce resources. Throughout the 1980s and 1990s, for example, the market for securitized assets grew rapidly-driven by the need for financial institutions to maximize their use of capital and fueled by banking assets ranging from auto to commercial loans. Financial derivatives also grew dramatically, as institutions found new ways to reallocate risks and rewards to where they were most valued. In the process, identifying and managing financial risk has become more complex.

It is, indeed, pressures created by market events that have brought about many of the advances in risk management that we have seen, and these advances have contributed to a more efficient and financially stronger banking system. For example, during the past five years, U.S. banks have been forced to improve their management of market risks as their trading activities became more complex and quadrupled in volume. Institutions have enhanced their information systems to report trading positions on a more timely basis and have also developed more sophisticated risk measurement techniques, such as the "value at risk" (VaR) measure currently used by many large trading institutions. This measure considers historical volatilities of market movements in calculating the probability of material and adverse changes in the market values of trading portfolios over the near term. Although specific techniques for calculating VaR differ among institutions and continue to evolve, such measures represent a significant advance in the management and measurement of market risks.

While no one should underestimate the potential risks in trading and derivatives activities, I would note that the overall experience of U.S. banks in this area has been favorable and that it has not been a source of material problems to the banking system. Even in the isolated cases in which we have seen large trading losses, as with Barings and Daiwa, the problems have related to fundamental violations of the basic tenets of sound internal controls, such as inadequate separation of duties, not with the inherent complexities of the instruments involved.

Moreover, credit risk, the risk that a borrower will default, has always been the most important risk to commercial banks and has also been a difficult risk for bankers to measure and control - whether or not it entails derivatives instruments. Nevertheless, here, too, opportunities for stronger risk management practices are growing daily as, again, technology makes more things possible. For example, through their own direct efforts and those of national consulting firms, banks are significantly improving their loan analysis and internal credit risk ratings to facilitate more efficient loan pricing and internal capital allocation relative to risk. Many banks are also devoting more resources to identifying correlations among default risks so that their risks can be diversified more effectively and managed on a portfolio basis.

Changes in Bank Supervision

All aspects of our supervisory process are undergoing changes in response to advances in risk management and industry innovation, including capital adequacy guidelines, the examination and surveillance process, and efforts to promote more public disclosure and appropriate accounting conventions. These and other initiatives are discussed briefly below and are listed in the attachment.1 Taken together, these efforts should improve both the efficiency and the quality of the supervision process while also reducing the related costs to the banking system.

The Federal Reserve has always placed much importance on strong capital adequacy among banks and sought nearly a decade ago to develop and promote capital standards that acknowledged changing practices within the banking system and that were more sensitive to a bank's risk profile. The previous primary capital standard served its purpose of strengthening capital ratios, especially among the nation's largest banks, but had clear limitations. The existing risk-based capital standard that was adopted by the Basle Committee on Banking Supervision (Basle Committee) in 1988 provided a mechanism, missing in the earlier standard, for addressing the growing volume of off-balance-sheet transactions and also distinguished among broad categories of credit risk in instruments booked on the balance sheet.

While the current requirement is, itself, still crude in many respects, it has given supervisors and the banking system a framework for evaluating capital adequacy that is more responsive to the level of credit risk than had previously existed in regulatory standards, and it continues to evolve to meet changing needs. For example, within the last two years, the risk-based capital standard has been amended to tailor capital requirements to a broader range of off-balance-sheet risks and to recognize practices within the financial industry to reduce credit exposures through netting arrangements.

Supervisors are also adapting the standard to take advantage of improvements in risk measurement methodologies to address market risks in trading activities, that is, the risk to an institution's trading position resulting from adverse movements in interest rates, foreign exchange rates, or commodity or equity prices. Such market risks were not covered by the risk-based capital agreement in 1989. Although appropriate rulemaking procedures remain to be finalized in the United States, the Federal Reserve and the other U.S. banking agencies expect in the coming months to adopt new standards that will permit large U.S. trading banks to use their internal "value-at-risk" models, subject to examiner oversight, to determine their future capital requirements for market risk. Recognizing not only the advances in risk measurement but also the importance of sound risk management practices, this forthcoming standard will require large trading institutions to meet certain quantitative and qualitative criteria. The quantitative requirements produce a level of consistency necessary for a capital standard, while the qualitative requirements provide specific standards for managing trading risks that include the following elements of sound risk management practice:

* A risk control unit that is independent of the trading function

* A regular program for backtesting the bank's performance to validate the accuracy of the VaR measure

* Procedures for periodic stress testing to evaluate the impact on a bank's condition of highly unusual market moves

* Documented internal policies, controls, and procedures

* Independent reviews of the risk management process by internal auditors.

At the end of February, the Board of Governors approved for public comment the final element of the market risk proposal that deals with "backtesting" the accuracy of a bank's internal model. We expect to complete the rulemaking process for this proposal this spring and to implement the new requirements by the end of 1997.

The vast majority of all derivative transactions of U.S. banking organizations are held in the trading accounts of the largest banks and, thus, will be covered by these market risk capital requirements and principles of sound management. As traded instruments, they are also market-to-market daily, actively managed, and incorporated into the institution's risk management reports. Derivative instruments are also subject to the counterparty credit risk provisions of the existing Capital Accord and continue to be subject to examiner review from that perspective as well.

In placing a high importance on the management process for trading and derivative activities, the Federal Reserve recognizes that these activities can rapidly change an institution's risk profile and transmit problems from one institution to another. Consequently, we have worked with our colleagues domestically and abroad to expand the expand the amount of information available to supervisors so that they can identify more efficiently institutions at which strong risk management and control procedures are most important. Early last year the U.S. banking agencies significantly enhanced the information about derivatives in their bank Call Reports to address the capital amendments mentioned earlier and to obtain other information about the underlying nature of derivatives' risks. These efforts also contributed, last year, to a joint framework for supervisory information" about trading and derivatives activities of banks and securities firms that was adopted by the Basle Committee and the International Organisation of Securities Commissions (IOSCO).

Other supervisory initiatives involve promoting and reinforcing sound risk management practices throughout the banking industry, training examiners in the underlying concepts of risk management and measurement, requiring more extensive "scoping" of a bank's risk profile before an examination, and providing examiners with the technology and guidance they need to make their efforts more efficient.

Evaluating Risk Management

One important step that reflects our increasing focus on risk management and controls is our recent decision to assign a formal rating to these areas in connection with on-site examinations beginning this year. While supervisors have long reviewed internal controls during examinations, the rating process will increase the focus on risk management and is intended to highlight both the quantitative and qualitative aspects of a bank's system for identifying, measuring, monitoring, and controlling its risks.

The rating of risk management will not alter the way in which our examiners apply the interagency CAMEL rating framework, but it will serve as a more solid foundation for determining the overall management component of that system. Moreover, we are also working with our colleagues from the other federal banking agencies to develop a consistent framework for incorporating market risks (including interest rate risk and foreign exchange risk) as well as risk management policies and practices more formally into the bank rating system.

Promoting Sound Practices

In many respects, the increased focus on risk management begins by identifying the practices that we expect banks to follow and that we direct our examiners to evaluate. While much is not new, the expansion of the more complex trading and derivatives activities has encouraged the Federal Reserve to formalize its expectations regarding sound risk management practices in several areas.

In all cases, of course, supervisory expectations may vary significantly, depending upon the size and complexity of the institution's activities. Large banks, for example, will normally be expected to have more formal policies, procedures, limits, and management information systems than smaller banks and must have more sophisticated measures of the risks they take. Nevertheless, all institutions are expected to follow basic sound management practices that are appropriate for their unique circumstances and the nature and level of the risks they take, whether those risks involve innovative and complex instruments or traditional forms of loans. This flexibility will inherently require judgment on the part of examiners and other supervisory personnel when assessing the adequacy of a bank's policies and procedures.

Since 1993, we have issued a series of instructions, policy statements, and examination manuals that have stressed the importance of managing all risks inherent in the business of banking, including market and credit risks, liquidity, legal, and reputational risks, and, quite important, operational risks. In these documents and throughout our supervisory process, we are emphasizing these four basic elements of sound risk management:

* An active oversight role by bank boards of directors and senior management. Directors, in particular, need not be experts in complex banking matters, but they should receive adequate information about their institution's risks that are measured and described in terms they understand and should communicate to management their tolerance for accepting risks. Directors and senior managers must ensure that the risks of new products are fully understood and that adequate controls are in place before new products are initiated. They also have the ongoing responsibility of ensuring that their directives are adequately implemented and enforced throughout the institution.

* Adequate policies, limits, and procedures. These elements should be tailored to the activities of the institution and should provide specific guidance regarding the nature and volume of risks the bank may take. Limits should be consistent with the board's willingness to take risks and with the institution's available capital and overall ability to manage its risks.

* Adequate risk measurement, monitoring, and management information systems. An institution should be able to identify and measure its material risks and clearly communicate their nature and level to senior management on a timely basis. Reports should identify instances in which established limits have been exceeded and should prompt appropriate corrective actions. The sophistication of the risk measures should be commensurate with the nature of the institution's activities.

* Adequate internal controls and audits. Having an internal control process that monitors adherence to established policies and procedures is critical to the sound conduct of a bank's activities. The complexity of control procedures may vary significantly among institutions, but to be effective they should all involve an appropriate segregation of duties, be administered by qualified personnel, and be conducted with sufficient independence, scope, and frequency. Especially at large institutions, examiners will be directing more attention to the independence of internal auditors and their ability to monitor and test the reliability of management information systems and compliance with internal policies and controls.

These principles are highly consistent with those promoted by the Group of Thirty in its 1993 report recommending sound practices in derivatives activities of financial institutions. Indeed, they are practices that virtually any business should employ in managing and controlling its risks. In that sense, efforts by the banking agencies to review and promote such practices should serve only to strengthen the financial condition and management process at banking organizations and to reduce the exposure a bank's activities may present to the federal safety net. This focus on risk management (particularly at large institutions) should in no way reduce the effectiveness of banking organizations to compete, either domestically or abroad.

I also would stress that while it is important for an institution to identify and document the policies, procedures, and controls it needs, simply maintaining the proper documentation is meaningless if the procedures and controls are not implemented in practice. Consequently, a critical aspect of evaluating risk management and control procedures is testing and validating the strength and integrity of the procedures and checking the extent to which they are understood and followed throughout the institution. Such validation efforts must be conducted by individuals who have proper levels of organizational independence and expertise, such as internal or external auditors, on-site examiners, or managers or other professionals within the institution with no direct connection to the activity being reviewed.

More Efficient Examinations

In addition to the actions I have outlined, the Federal Reserve has undertaken other initiatives to make the supervision process more efficient and risk-focused, while reducing the burden on banking organizations. For example, through administrative changes and by making greater use of available technology, we are increasing the time devoted to planning and preparing for an examination in order to tailor the examination to the unique circumstances and risk profile of individual institutions.

Both the planning and the on-site examination effort will be helped significantly with the introduction of the Examiner Workstation, which has been recently developed by the Federal Reserve System. This automated system, which is being tested in cooperation with state and federal banking agencies, permits examiners to download data directly from a bank's computer, analyze portfolios on their personal computers, and identify concentrations and other characteristics within the bank's loan portfolio. As a result, examiners should be able to reduce materially the amount of time they spend on manual operations and should be able to devote more time to identifying and evaluating risks. The Federal Reserve is also making greater use of loan-sampling techniques to test the accuracy of internal loan risk-rating systems and to improve the efficiency of the examination process.

In addition to these steps, we are also engaged in an ongoing, in-depth review of our examination and supervisory processes. Our long-term objective is to make the examination process even more riskfocused, cost-effective, and burden-sensitive without sacrificing the quality of our examinations and their ability to identify and evaluate fundamental safety and soundness considerations.

The risk orientation of our supervisory process also benefits from other factors. Recently we have supplemented information from our senior lending officer survey by initiating a quarterly survey of bank examiners that will give us more timely "hands-on" feedback on important developments relating to credit quality and management practices in banking organizations.

Training

Although examiners review the risk management process in all activities of a bank, most of the recent efforts of the Federal Reserve to train examiners about risk management practices have been directed at the more rapidly evolving activities of banks - particularly those involving market risks. These activities include trading and derivatives activities and those of typical asset-liability committees (ALCOs), which oversee a bank's investment portfolios and overall management of interest rate risk. In these areas, the Federal Reserve has significantly expanded its formal capital markets training programs to address risk management, including internal controls, at all levels of examiner expertise.

Capital Markets Coordinators

In recent years, the Federal Reserve's training and capital market surveillance efforts have been facilitated by capital markets coordinators at each Reserve Bank. These individuals, who are officers or senior examiners, keep abreast of market activities of institutions in their Districts and meet together quarterly to discuss supervisory policies and practices and to share their insights and experiences with coordinators from other Reserve Banks. They also participate actively in planning and staffing examinations and have helped significantly in developing and directing conferences and training programs that focus on the risk management of trading and derivatives activities. The Board staff has worked closely with these coordinators in developing examiner guidance and in implementing surveillance screens for monitoring and evaluating interest rate risk. We are also working with the other federal banking agencies to revise the Call Report to further strengthen our oversight and supervisory efforts in this area.

The Federal Reserve's capital market supervisory activities also benefit greatly from the experiences and insights of its research economists and payment system experts, at both the Board and the Reserve Banks. These individuals complement the skills and perspectives of supervisory personnel and contribute to a stronger supervisory process. Their contributions are particularly helpful with respect to risk management and market risk issues, which are likely to become even more important to supervisors in the future as market practices, risk management procedures, and financial innovations continue to evolve at a rapid pace.

Disclosure and Accounting Standards

While capital requirements and supervisory oversight are important in maintaining a financially sound banking and financial system, market discipline can also help greatly in stifling undesired behavior and reinforcing supervisory efforts to encourage sound risk management practices. For that reason, the Federal Reserve has worked at both the domestic and international levels to promote adequate and more uniform standards of supervisory reporting and disclosure, particularly with respect to internationally active banking organizations. We are also supporting the accounting profession in improving accounting and disclosure standards.

CONCLUSION

Efforts of the Federal Reserve to expand the review of a bank's risk management process are important, particularly in the case of large institutions and those with material holdings of derivatives and other complex instruments. These institutions and activities must be well managed or they will present unacceptable risks to the federal safety net. Our examiners will be devoting more attention than in the past to reviewing a bank's processes and controls, whether they relate to transactions or products new to the bank or to traditional lending activities. Although our goal is to ensure that risk management practices are commensurate with risks, we want to encourage all institutions to keep abreast of new techniques for improving their management of risks.

The greater attention given to risk management should not, however, be overstated and viewed as a more dramatic change than it is. Strong management procedures can go far in preventing problems throughout a bank, but evaluating their real worth is difficult without judging the bank's results. Assessing "old fashioned lending" and evaluating loan quality and the adequacy of bank capital and loan-loss reserves will remain paramount.

Of course, no set 'of supervisory procedures will detect or prevent all problems, and that should not be our goal. In the past, some banks - large and small - have had difficulties because of poor policies and procedures and have failed as a result, typically because of bad loans. Human nature being what it is, there will undoubtedly be more problems ahead - both for banks engaged in traditional lending activities and for those involved in trading and derivatives activities. Our job as supervisors should be to limit the frequency and scope of these problems and ensure that they do not present unacceptable risks to bank customers, the financial system, or the federal safety net. Toward that purpose, we will continue our efforts to review and improve supervisory techniques and encourage sound risk management practices, while recognizing that banks must take risks if they are to be in a position to serve their customers and communities and fulfill their role in the nation's economy..

(1.) The attachment to this statement is available from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551.