In particular, the Committee observed an imbalance among the key elements of the credit risk management process, with too strong a reliance upon collateral to protect against credit losses. 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. The Credit Approval Process For a bank to make sound lending decisions, it needs to obtain sufficient information about the borrower. Supervisors routinely emphasize the need for banks to have an effective credit approval process consisting of formal policies and procedures, accompanied by documentation of actual credit decisions. I should note that banks’ credit exposure to LTCM was in two forms: the exposure arising from the trading of financial products with LTCM, and the exposure stemming from loans made to LTCM. Banks’ primary exposure to LTCM was through their trading activities. Loans were not a large factor in the events that transpired last fall. Regardless of whether a bank is a trading counterparty with, or a direct lender to, an HLI, it must obtain comprehensive and timely financial information about that HLI’s risk profile and credit quality, and it must perform 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.
But I do not think that problems involving unwise exposure to HLIs can fairly be blamed on the fact that many of these entities are chartered offshore. To be sure, the due diligence review that banks make for every customer should encompass the customer’s place of incorporation and its ramifications. Currently, I know of no comprehensive direct regulation of hedge funds in any of the G-7 countries. There are, however, aspects of hedge fund activities, such as commodities and futures trading, that are subject to regulatory oversight. I do not believe that it would be easy to develop a workable approach to the direct oversight of hedge funds. The reality is that imposing direct regulation on hedge fund entities that are chartered in the major industrialized countries would likely result in the movement of all operations to sites offshore. Direct regulation of hedge funds would require a high level of coordination involving the political, legislative, and judicial bodies of many countries. This is clearly beyond the jurisdiction of most banking supervisors. As bank supervisors, we have opted for a strategy that will, I believe, bring substantial nearterm results. Our approach to improving the financial system’s interactions with HLIs is to focus quickly and aggressively on the decisions by banks that could create excessive leverage or imprudent credit exposure. Perhaps our strategy can be termed “indirect”, but I am reasonably confident that it will succeed.