Some commentators have sought to draw a sharp distinction between the approach to financial regulation in the United States and that in the United Kingdom. These observers have characterized the British approach as being principles-based and as using a "light touch"--the implication being that these two features somehow go together. In a speech in February of this year, Sir Callum McCarthy, the head of the United Kingdom's Financial Services Authority (FSA), took issue with this interpretation.¹ Sir Callum confirmed that the FSA's approach is built on a framework of principles, although he noted that the FSA also has an 8,500-page rulebook to accompany the eleven principles it has laid out. But the FSA head rejected the view that their approach is "light touch." Rather, he said, it is risk-based, which means that regulatory resources and attention are devoted to firms, markets, or instruments in proportion to the perceived risks to the FSA's regulatory objectives.

...I have argued today that we should strive to implement a regulatory regime that is principles-based, risk-focused, and consistently applied. Enhancing market discipline can complement and strengthen such an approach. As in the United Kingdom, a principles-based approach is not inconsistent with the use of rules, which can provide needed clarity or a safe haven from legal and regulatory risks. However, rules should implement principles rather than develop in an ad hoc manner.

The subprime situation may well be a blessing in disguise.  It reminds us that history does have the capacity to repeat itself.  The old financial axioms — levelheaded notions such as “know your customer” (or your counterparty) and “there is a difference between price and value” — remain valid.  I expect market discipline to reassert itself, swiftly punishing those who pressed the limits of imprudence or suffered selective amnesia, hopefully doing so in a way that staves off the impulse for lawmakers and regulators to interfere disproportionately. 

In addition to monetary policy, the Federal Reserve performs other duties to help achieve our broad mandate of supporting a safe and efficient monetary and financial system. In our market economy, we rely on private banking and financial markets to mobilize and channel savings to productive investments. So we promote public confidence in this system and improve its efficiency through bank supervision and by our active involvement in the operation of our nation's payments system.

What should policymakers to do mitigate these risks?

We cannot turn back the clock on innovation or reverse the increase in complexity around risk management. We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system. We cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.

The most productive focus of policy attention has to be on improving the shock absorbers in the core of the financial system, in terms of capital and liquidity relative to risk and the robustness of the infrastructure.

These risk-management challenges have not gone unnoticed by market participants themselves.  In 2005, a private-sector group, the Counterparty Risk Management Policy Group II, or CRMPG II, chaired by E. Gerald Corrigan, produced a report highlighting many of these issues.⁹  

...CRMPG II called attention to the growing backlogs and the risks that they posed to market participants and called for the convening of an industry roundtable to address them.¹⁰  Prudential supervisors then took the lead.  In September 2005 they called fourteen leading dealers to the Federal Reserve Bank of New York, where the supervisors collectively made clear their concerns about the risks posed by the growing backlogs.

The supervisors wisely avoided any temptation to design their own improvements to the market infrastructure.  Instead, they simply insisted that the backlogs be reduced and left it to the dealers who had been at the meeting (and who became known as the Fed 14) to figure out with other market participants how best to achieve that objective.  The market participants recognized that automation was the key; manual processes simply are not scalable.  Both dealers and asset managers embraced use of the Depository Trust & Clearing Corporation’s Deriv/Serv electronic confirmation service.

Relationship finance continues to be at the heart of community banking. I believe that the most significant characteristics of community banks are: 1) their importance in small-business lending; 2) their tendency to lend to individuals and businesses in their local areas; 3) their tendency to rely on retail deposits for funding; and 4) their emphasis on personal service.  Hence, successful community banking today depends importantly on the same characteristics that formed the foundations of the U.S. banking industry two centuries ago--personal interactions among bankers, their customers, and their communities.

...

Along with the benefits of relationship finance, however, come some risks, including the potential for conflicts of interest. This particular risk appears to have been mitigated significantly in the United States, although it is important for bankers to remain vigilant and to regularly review the corporate governance mechanisms they have in place.

[S]upervisory authority in a number of countries abroad has been consolidated and separated from central banks; these moves have forced the new regulators and their central bank colleagues to learn how to operate not only in a new financial landscape but also in a new regulatory environment.

One result of this changing financial environment is to make a risk-based approach to capital requirements more essential, particularly as countries deregulate their financial markets and remove provisions that once served to limit risk taking.

In the remainder of my remarks, I will discuss some economies of scope arising from the combination of bank supervision and other central bank responsibilities...

My point today is a narrower one:  that the supervisory authority of the Fed has significant collateral benefits in helping it carry out its responsibilities for financial stability.  In particular, the information, expertise, and powers that the Fed derives from its supervisory authority enhance its ability to contribute to efforts to prevent financial crises; and, when financial stresses emerge and public action is warranted, the Fed is able to respond more quickly, more effectively, and in a more informed way than would otherwise be possible. 

The Fed undertook similar discussions with other supervisors and with financial firms in response to the failure of Drexel Burnham Lambert in 1990 and the collapse of Long Term Capital Management (LTCM) in 1998.  As the condition of Drexel deteriorated, other firms became less willing to trade with it, making it difficult to wind down its positions in an orderly manner (Breeden, 1990).  Because of the Federal Reserve’s ongoing supervisory relationships with the main clearing banks and its detailed knowledge of the payments system, the Fed was able to address the banks’ concerns and facilitate the liquidation of Drexel’s positions (Greenspan, 1994).  In the case of LTCM, the Federal Reserve had the credibility with large financial firms to facilitate a discussion, from which emerged a private-sector solution that helped to avoid potential market disruptions (Greenspan, 1998).

I believe that supervisory oversight is in pretty good shape, with one glaring exception. Government-sponsored enterprises are not adequately capitalized and the supervisory powers of the Office of Federal Housing Enterprise Oversight (OHFEO) are inadequate. I’ll concentrate on the housing GSEs—Fannie Mae and Freddie Mac. This is a topic I’ve addressed several times in the past (Poole, 2003 and 2004) and I’ll not repeat those arguments in any detail here. Although the GSEs are not formally insured by the federal government, the market clearly believes that they are effectively backstopped.

Good regulatory and supervisory policies should implement congressional intent in ways that maximize social benefits and minimize social costs. The regulatory burden on banks is not the only element of social cost, but it is an important component. Accordingly, in developing regulatory and supervisory policies, the Federal Reserve and the other banking agencies will continue to pay close attention to the implications of those policies for regulatory burden, competitiveness, and efficiency in banking.

I'd like to spend a few minutes discussing the outlook for both residential and commercial real estate in the context of the current regulatory focus on the banking industry's lending to these sectors of the economy.

In fact, the San Francisco Fed has a long-standing supervisory interest in real estate conditions. We helped shape the current draft interagency guidance on commercial real estate concentrations, and our institutional memory of the devastating California real estate downturn in the early 1990s remains vivid. Frankly, it would be hard to forget that period, when California had 49 commercial bank failures between 1991 and 1996, accounting for about 11 percent of the state's banks. The vast majority—as well as many banks that survived in troubled condition—had very high construction loan concentrations for either commercial or residential properties, or both.
Of course, circumstances have changed a lot since then. For example, there is now ready access to information on real estate market conditions and active secondary markets for real estate loans; and certainly, bank underwriting practices have improved significantly. While these changes have helped to mitigate risk, we can't afford to become complacent; as history has taught us, concentrations still can prove dangerous when market conditions turn.

As you know, the performance of commercial real estate and construction loans on banks' balance sheets has been excellent, largely because of low interest rates and substantial appreciation of property values. These conditions may have encouraged banks to focus new lending towards these sectors—especially construction and land development. Although California banks no longer lead the nation in construction loan concentrations—as they did in the previous real estate cycle—more than 40 percent of the state's banks exceed the benchmark ratio contained in the draft interagency guidance, which, as you know, is 100 percent of total capital.
Construction lending causes some concern at this point in the cycle because our examiners have found that much of the recent loan growth in community and regional banks is in the softening residential market. The riskiest loans are those for land acquisition and speculative development; historically, these are the first to register the effects of a slowdown in terms of weakening demand for new loans and declining quality of existing loans. If housing markets continue to slow, such banks should watch closely for signs of trouble, such as project delays, houses not selling, price discounts, condos converting to rentals, and increasing loan renewals, extensions, and refinancings. Any of these developments could have a significant impact on revenue and growth projections as well as loan losses at some banks.

As the draft interagency guidance states, we expect banks to actively manage risk concentrations in commercial real estate and construction lending. Tomorrow, Jose will discuss some of the ways that banks are enhancing their approach to credit risk concentration management. Based on what we've seen in recent examinations, I'm pleased to say that it appears that a number of banks have already implemented most of the risk management practices outlined in the proposed guidance.

The collaborative process that produced this progress {on credit derivatives clearing} has much to recommend it. What principles led to this outcome?

First, regulators and supervisors -recognised that they were more likely to achieve their goals if they worked with the private sector in the development of solutions to complex problems. In this case, supervisors laid out broad objectives but let the market design the solution. Working with the market may be necessary to keep pace with changes at the frontier of innovation.

Second, to fix the credit derivatives problem it was necessary to involve a large and diverse pool of financial institutions. No firm or national authority had the capacity to make progress on its own. To correct this collective action problem, firms needed confidence that competitors would be held to similar standards. Having firms set common metrics and insisting on sharing aggregate reporting data with the entire group ensured that each firm could measure its progress against the group, discouraging individual firms from free-riding or circumventing the group's effort.

Finally, in a more integrated global market, we will increasingly find ourselves compelled to pursue borderless solutions. In the case of derivatives, a local or national solution would have been insufficient to protect domestic financial markets from the risks posed by market practices.

FT article co-authored with Callum McCarthy and Annette Nazareth.

I have always been a great defender of the proposition that the Federal Reserve should be the leading regulator and supervisor of banks. There are other agencies involved, but when push comes to shove because of lenders' last resort position, in other words, Federal Reserve has a special responsibility and once you control the banking system, that was enough and the rest of the market ought to go on its own.

 Well, that was fine when commercial banks were 60% or 70% of the financial system and we're a long, long ways from that and in fact, what we still call the big commercial banks, aren't commercial banks anymore. That's kind of a subsidiary operation and they all want to become investment managers and investment banks and insurance companies and all sorts of things. Which really raises the question of whether the - what we have in law is the traditional supervisory distribution of authority, is really relevant.