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.
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 1  BIS Review 27/1999  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 1 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.