Dr. Bill.

• Author: BERRY, JOHN M.
• Position: New York Federal Reserve President Bill McDonough

New York Federal Reserve President Bill McDonough wants to inoculate the global system against bank meltdowns. His prescription: upgraded capital standards and improved risk management.

Like an overmatched professional football team, banking supervisors in the industrial nations have been playing an urgent game of catch up most of the past two decades. Each time they think they have tied the score or perhaps gained a small lead, an unexpected new play by innovative market forces leaves them in the dust, sometimes in the midst of a global financial crisis.

After each such episode, the banking supervisors vow to come up with a better defensive plan before the next game. But many public officials, bankers, and experts in international finance are still fearful that, even as the rules for financial institutions are tightened, there remain hidden channels through which an unpredictable shock in one location could trigger yet another systemic crisis. And as events in 1994, 1997, and 1998 proved so conclusively in Mexico, Thailand, South Korea, Indonesia, and Russia, among other places, dealing with a financial crisis after it hits is extremely costly in both financial and human terms. Preventing them in the first place -- if it can be done -- is by far the better way to go.

In each of those crisis countries, the banking system was in deep trouble if not bankrupt before the financial storm struck. Other factors, such as unsustainably heavy borrowing in foreign currencies, pegged exchange rates, large current account deficits, or a regional contagion, may have been the proximate trigger for each country's crisis. However, the damaged condition of their banking systems made each situation far worse. The banking systems were in poor shape despite the fact that most of them were among the more than 100 nations which had formally accepted the 1988 Bank Capital Accord promulgated by the Basel Committee on Banking Supervision. That committee, a creation of the G10 central bank governors, is based in Basel, Switzerland, at the headquarters of the Bank for International Settlements (BIS).

The 1988 Accord was an outgrowth of the Latin American debt crisis of the early 1980's that left virtually all of the biggest U.S. banks under water. It was intended to ensure that banks had an adequate cushion of capital to absorb large losses. The amount of capital deemed adequate was tied to a formula based on the riskiness of an institution's assets. That crisis had killed the notion, most prominently held by Walter Wriston, then chairman of Citibank, that an institution could safely get by with a minimum amount of capital if its assets were sufficiently diversified.

Banks did increase their capital after the 1988 Accord was widely adopted, but by the mid-1990's, it had become clear that the standards were no longer doing the job. Many institutions had found ways to hold extensive off-balance-sheet assets that added substantially to risk but carried no regulatory capital requirement. And some of the risk weightings in the 1988 Accord actually had turned out to be ticking time bombs.

In response, the Basel Committee, under the chairmanship of William J. McDonough, president of the New York Federal Reserve Bank, is putting the final touches on a new, far more comprehensive accord that has been more than two years in the making. The 1988 Accord, McDonough says, had become "outdated and ... therefore counterproductive."

"The 1988 Accord" McDonough told a conference of bank supervisors in Basel in September, "was, without question, a milestone achievement -- for the first time supervisors were able to use a common yardstick for assessing banks' capital adequacy." "In recent years, however, the Accord has exhibited serious shortcoming. One significant weakness is that the Accord's broad-brush structure may provide banks with an unintended incentive to take on higher risk exposures without requiring them to hold a commensurate amount of capital. It also has not kept pace with innovations in the way banks measure, manage, and mitigate risk," McDonough said.

A much-revised draft of the new accord should be unveiled in January for the last round of public comments, and should be ready for adoption by next summer. It has what McDonough calls three "pillars":

* New, more detailed risk weighting for different types of assets, with large, internationally active banks expected to use their own models for internal ratings for credit risk. Smaller institutions will use a more standardized approach. In some instances, particularly for sovereign risks, assessments by external agencies, such as Moody's Investors Services, may be used, at least initially.

* Supervisors will evaluate how well banks assess their capital needs relative to their risk profiles and ensure institutions take corrective actions when needed.

* Finally, institutions will be expected to meet a set of disclosure requirements that will make enough information available to the public to allow the market to assess whether a bank has enough capital -- in other words, allow market discipline to work.

In June of last year, the Basel Committee released for comment what it called a "consultative" paper outlining the three pillars and how they would be expected to work in practice. For the next nine months, interested parties poured over those details and found quite a few they didn't like, though none of the comments received by the March 30 deadline argued for keeping the old Accord. The pending draft has been altered extensively in response to many of those objections.

McDonough, a persuasive, sophisticated man, well versed in international finance, has been president of the New...