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Speeches and Testimony |
Ricki Helfer Chairman Federal Deposit Insurance Corporation before a Symposium on Credit Derivatives Sponsored by the FDIC Arlington, VA April 4, 1997
In recent years, there have been questions about the value of
bank supervision and regulation. Given our current, extraordinarily
stable economic environment -- and the tremendous profits that banks
have been able to make as a result -- this criticism should come as
no surprise -- memories can be short in good times. Because a
high tide lifts all ships, strong and effective supervision and
regulation may appear to some people as less necessary in good times.
When the tide runs out and economic strains reveal the weaknesses
at institutions, however, no one questions the utility of banking
supervision and regulation -- in fact, quite often, there are
calls for more.
Banking supervision and regulation seek to impose on bankers a
discipline that common sense would otherwise require. Most bankers
have common sense, and so the advocates of less regulation argue that
supervision is unneeded. The target of supervision is not the bankers
with common sense, however, it is the bankers who fail to demonstrate
common sense.
That principle is not new. Franklin Roosevelt noted in a radio
address in 1933 that "the acts of a comparative few [bankers] had tainted
them all" in the banking crisis that led to the creation of the
FDIC -- a crisis illustrated in the period photographs hanging on the
walls of this room. Bank supervision and regulation seek to maintain
stability in the marketplace by preventing or isolating the acts of a
comparative few from tainting others. Certainly, there is a price for
that stability -- but these photographs remind us that there is a larger
price for instability.
This symposium offers us an opportunity to examine the value
of banking regulation as it affects credit derivatives and affords
participants the opportunity to shape the analysis that will guide
their future regulation.
Last year the FDIC hosted a symposium here on the capital
markets. In January, we hosted a symposium on the lessons from the most
recent banking crisis. We sought to learn from the past so that we could
work toward a better future. Both symposia reflect the FDIC's commitment
to the process of risk assessment -- to moving ahead of the curve in the
markets -- so that we can stay on top of developments. Our goal in risk
assessment is to be able to address problems before they threaten the safety
and soundness of individual institutions, as well as cause losses to the
insurance funds.
That commitment also resulted in our creating a Division of Insurance,
which identifies, monitors, and assesses risks in the financial system and
the economy to provide economic and financial data to our examiners, as well
as early warnings to bankers of negative trends in the industry and the
economy. That commitment has led us to a systematic analysis of the causes
of the 1,617 bank failures and assistance transactions from 1980 through
1994, which establishes a base-line reference both for research and for risk
assessment that will help us to identify trends that could affect the future
health of the deposit insurance funds. Given the explosive growth in credit
derivatives in recent years, I thought that we should follow up with a
symposium focusing more particularly on this new product.
Financial derivatives generally facilitate the intermediation of
market risk, which has been extensively quantified and, therefore, is open
to sophisticated analysis. Credit derivatives, however, permit the
unbundling and intermediation of credit risk, which has traditionally been
managed, loan-by-loan, by bankers using their judgment to apply underwriting
standards. A great deal of banking regulation and supervision, especially
in modern times, has dealt with the adequacy of an institution's underwriting
standards. It is judgment in applying underwriting standards that ostensibly
separates bankers from the remainder of humanity.
In applying credit judgment, however, bankers have a less-than-perfect
record. As we found with Penn Square and Continental Illinois in the early
1980s, even with far less complex arrangements than derivatives represent,
poor credit judgment can lead to disastrous losses. Moreover, in
systematically analyzing the failure of 1,617 institutions in the banking
crisis of the 1980s and early 1990s, we found that banks generally failed
the old fashioned way -- by making bad loans. That was as true for larger
banks as it was for smaller ones. Ultimately, these failures depleted the
FDIC insurance fund.
Because credit risk lies at the heart of credit derivatives, the
bank regulator and deposit insurer must view them, first and foremost, as
loans and pieces of loans. As with any loan, the question is: "How solid
is the credit judgment backing up this loan?" Every bank that holds a
credit derivative, regardless of who originated it, should know the
answer to the question. In this period of infancy, most credit derivative
contracts have been concentrated among the better credits, but if the market
is to expand, they will be extended to lower-rated credits, which adds to
the importance of understanding that a credit judgment is being made.
The real issue is whether a credit derivative is different than
other loans. To answer that question sensibly, regulators need to
understand the purpose and function of credit derivatives in the real
world context in which they are used. Our challenge is to identify the
risks embedded in credit derivatives and establish appropriate standards
for those risks -- including appropriate capital requirements under the
Basle risk-based capital accord.
Credit derivatives have given rise to concerns at the federal
bank regulatory agencies. To address some of those concerns, the agencies
last August issued preliminary guidance to examiners on how to treat credit
derivatives during examinations, including a framework for analyzing the
risks incurred by insured financial institutions that use them. The guidance
stresses that banks should have sound risk management policies and
procedures, including adequate internal controls, in place for credit
derivatives. The guidance also stresses that any bank engaged in credit
derivatives, either as beneficiary or as guarantor,
must perform an analysis of the credit risk involved in the instrument. We
noted in August, however, that bank regulators in the U.S. and in other
countries were continuing to analyze the new instruments and our discussions
could result in revised or additional supervisory guidance. In addition,
a few institutions affected by the guidance have raised questions about it.
This symposium is intended to help the FDIC understand the effect of the
preliminary guidance on the market for these instruments, as well as to
gather facts that will help us learn more about what credit derivatives
are and what they do for purposes of developing more definitive
guidance.
We have assembled a wide range of participants here today to
discuss the emergence of the market for credit derivatives; the economic
forces shaping that market; and the regulatory, legal, and accounting
issues that are relevant to the market. I want to welcome you this morning
and to thank you for contributing your time and expertise to this
important effort. I am sure there will be a stimulating exchange of ideas
from every one on the dais and in the audience. This discussion will lead
us to formulate an approach that makes the most sense in connection with
the real world evolution of the credit derivatives market.
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Last Updated 06/25/1999
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