Statement by William J. McDonough, President, Federal Reserve Bank of New York, before the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises of the Committee on Banking and Financial Services, U.S. House of Representatives, March 3, 1999 - lessons learned from near collapse of long term capital management

Federal Reserve Bulletin, May, 1999

When I appeared before the full committee in October, I spoke about the near-collapse of Long-Term Capital Management (LTCM) and the events leading up to the private-sector recapitalization of its fund, Long-Term Capital Portfolio. At that time, I promised you that we would take a hard look at the issues growing out of that experience, particularly as they affect our responsibilities as bank supervisors. I am pleased to appear before you today to report on the lessons we have learned and the actions we have taken to reduce the possibility that such an episode could repeat itself in the future.

As I indicated last fall, three issues require particular attention by banks and their supervisors in the wake of LTCM. These are, first, the adequacy of banks' credit analysis processes; second, the effectiveness of exposure measurement; and third, the role of stress testing of counterparty exposure. In my remarks today I will detail the substantial progress that has been made, both domestically and internationally, to address each of these supervisory concerns.

But before I get into the details, let me say that I believe the LTCM episode and the supervisory response to it is fundamentally about two things: leverage and good judgment. Leverage is a fact of life in our financial world and is a key part of the risk-taking necessary for the creation of wealth. But sometimes banks go too far in extending credit to their customers and counterparties. That's where good judgment comes in. I know--I've been there. I was a commercial banker for twenty-two years before becoming President of the New York Fed, and I can tell you that the most important decisions a banker makes are how to lend and to whom. Those decisions are not easy and often involve many shades of gray. One of our aims as supervisors should be to see that banks are using the right tools to make those judgments.

The importance of these issues extends beyond banks and their supervisors. Sound credit policies and procedures are essential not only for the stability of individual banks but also--and more important--for the health of the financial system and the economy as a whole. This is because banks play a pivotal role in our economy as providers of credit. If banks make poor credit decisions with respect to a borrower, including a hedge fund like LTCM, the financial system and our economy will suffer.

BASLE REPORT FINDINGS

As you know, I chair the Basle Committee on Banking Supervision, comprised of bank supervisors from the G-10 countries who coordinate supervisory policy for internationally active banks. While the committee does not have formal legal enforcement powers, its conclusions and recommendations are widely implemented, both in G-10 countries and many others. In late January, the committee issued a report dealing with the relationship between banks and highly leveraged institutions, or HLIs. The committee's report provides a framework for addressing the broader issues raised by the LTCM episode, the policy responses of supervisors, and some key risk-management challenges for the banking industry going forward.

In the United States, the Federal Reserve System, the New York State Banking Department, and the Office of the Comptroller of the Currency have conducted target reviews of a number of large-bank dealings with hedge funds. These reviews contributed to the committee's work, to the Federal Reserve System's issuance on February I of new guidance to financial examiners and banks, and to similar guidance from the Comptroller of the Currency issued in January. These new standards emphasize the need for improvements in the credit-risk-management process at banks. The new standards will likely be complemented by a study of the implications of the LTCM episode by the President's Working Group on Financial Markets.

Because the Basle Committee's jurisdiction is limited to matters of banking supervision and regulation, its primary emphasis has been on ensuring that the major banks prudently manage their risk exposures to HLIs. The best way to achieve this is through the adoption of sound practices by the industry, perhaps supplemented by incentives created through capital requirements. While it is primarily the responsibility of each banking organization to manage its risks, sound practice standards give banks and supervisors a tool to measure industry progress. If banks themselves do not follow sound practices, then supervisors must step in and take the necessary action.

The committee's report revealed a number of deficiencies. In particular, the committee observed an imbalance among the key elements of the credit-risk-management process, with too strong a reliance upon collateral. This undue emphasis, in turn, caused many banks to neglect other critical elements of effective credit risk management, including in-depth credit analyses of counterparties, effective exposure measurement and management techniques, and the use of stress testing.

Credit Approval Process

For a bank to make sound lending decisions, it needs to obtain sufficient information about the borrower. Supervisors routinely stress the need for banks to have an effective credit approval process consisting of formal policies and procedures, accompanied by documentation of actual credit decisions. When dealing with an HLI, a bank also must obtain comprehensive and timely financial information about that HLI's risk profile and credit quality, and it must engage in an ongoing credit analysis of that HLI. In addition, a bank must have a clear understanding of an HLI's operations and risk-management capabilities. The committee observed weaknesses in each of these areas. Let me give a few examples.