This paper was presented at the conference "Financial services at the crossroads: capital regulation in the twenty-first century" as part of session 6, "The role of capital regulation in bank supervision." The conference, held at the Federal Reserve Bank of New York on February 26-27, 1998, was designed to encourage a consensus between the public and private sectors on an agenda for capital regulation in the new century.Bank capital ; Bank supervision

Christine M. Cumming

English

Research Papers in Economics

FRBNY ECONOMIC POLICY REVIEW / OCTOBER 1998 225
Commentary
Christine M. Cumming
In commenting on the three thought-provoking papers in
this session, I would like to consider the first two papers
together and then turn to the third.
From the standpoint of methodology, the first two
papers could not be more different. The Estrella paper
blends analytical and historical methodologies, with
attention to supervisors’ own understanding of their
policies and practices, to consider the appropriate role of
formulas and judgment in the supervisory assessment of
capital adequacy. The Kupiec and O’Brien paper considers
a series of results in the literature in the context of a more
general model. Paul Kupiec and Jim O’Brien have done a
great service in their paper by bringing these strands of the
academic literature into a common framework. They help
us to understand better the role of capital requirements and
the interaction of capital requirements with risk manage-
ment, the public safety net, and the short- and long-run
optimization problems of firms, where franchise value is
interpreted as capturing the long-run value of the firm as
an ongoing concern. 
The themes in the two papers, however, are very
similar. Estrella emphasizes the dynamism and complexity
of the financial system and, more particularly, of the rules
and conventions that guide financial institution and super-
visory behavior. In doing so, he draws on literature beyond
economics that discusses the phenomenon of reliance on
judgment and interpretation in the crafting and execution
of rules and conventions. Reliance on simple quantitative
rules applicable to all institutions—in Estrella’s language,
formulas—cannot work as supervisors would like them to. 
In their paper, Kupiec and O’Brien make much
the same point by generalizing the models used in the
literature on capital requirements and deposit insurance
pricing. Well-known policy prescriptions developed in
models with certain assumptions change markedly with
the relaxation of even one or two assumptions. In particular,
for banks with different strategies or different investment
opportunities, the “optimal” capital requirement—the
requirement that shareholder value is maximized but moral
hazard is minimized—is bank-specific. No two capital
requirements are likely to be the same. 
In both the Estrella and the Kupiec and O’Brien
papers, the development of bank-specific requirements
entails large amounts of information and a degree of preci-
sion that is not reasonable to expect of anyone, except the
owners of the firm. As the world becomes more analytical,
precise, and complex, it becomes all the more difficult to
specify simple and hard-and-fast regulatory rules. 
Christine M. Cumming is a senior vice president at the Federal Reserve Bank of
New York.226 FRBNY ECONOMIC POLICY REVIEW / OCTOBER 1998
Yet both papers see a role for capital require-
ments—to limit moral hazard, to benchmark information,
and to provide a cushion to limit the social costs of a bank
liquidation. If we look beyond these papers to actual prac-
tice, formulas such as minimum capital requirements
appear to have additional purposes. Such requirements
shorten the negotiation time to agreement between firm
and supervisor on appropriate capital levels by providing a
lower bound to the possible outcomes. A related consider-
ation is transparency. Since the regulator has statutory
powers to enforce capital adequacy, the considerations
influencing its evaluation should be known to the financial
firm, and the government should be able to demonstrate
capital inadequacy in setting out any remedial action.   
What, then, do the conclusions in these papers
mean for supervisors? 
First, capital requirements will necessarily be
imperfect and have only temporary effectiveness. Second,
the increasing sophistication and complexity of risk man-
agement in financial institutions call for more judgment in
assessing capital adequacy. Third, capital cannot be consid-
ered in isolation, but has to be understood in the context of
strategy, investment opportunities, risk management, and
the cost of equity issuance. Capital requirements need to be
seen in the broad context of supervisory activity, and
capital adequacy supervision must necessarily involve some
elements of supervisory judgment. Fourth, the conclusions
in these papers help explain why we increasingly see a link
between the quality of risk management and various
supervisory rules and permissions. For example, the inter-
nal models approach includes both qualitative and quanti-
tative criteria. With prompt corrective action and under
the recently revised Regulation Y in the United States,
limitations on activities and requirements to seek regula-
tory permission to conduct activities can be triggered by
supervisory judgments, as reflected in the CAMEL or
Management ratings given by U.S. supervisors during
a bank examination. Finally, the results also help to
explain the appeal of “hybrid” approaches described
by Daripa and Varotto and by Parkinson; the supervi-
sory approach described in Estrella’s 1995 paper, “A
Prolegomenon to Future Capital Requirements”; and
the approach described in the Shepheard-Walwyn and
Litterman paper. 
In reading the Frankel paper, I found myself sur-
prised. After the breadth of perspective in the previous two
papers, Frankel moves the point of perspective higher and
further back to survey the broad global scene, and gener-
ates the shock of the unexpected—the problems we just
considered in Estrella and in Kupiec and O’Brien are yet
more complex. The shock is reinforced by the contrast
between the elegance of the two earlier papers and
Frankel’s candid observations.
Frankel’s paper considers two sets of issues. First,
he points out that certain preconditions have to be met for
financial supervision to have any meaningful role. These
preconditions include meaningful financial statements,
publicly available on a timely basis, and a clear set of rules
determining what happens when debtors cannot pay. In
other words, we need to have adequate accounting, disclo-
sure and bankruptcy principles established and applied in
every country active in the international financial markets. 
No one in this room is likely to disagree openly
with his point. Frankel argues that the absence of these
preconditions in some countries contributed to and exacer-
bated the recent crisis in Asia. Moreover, that crisis does
seem to have created a defining moment for G-10 super-
visors and central banks. The G-10 official community
shows every sign that it agrees on the need to strengthen
global accounting, disclosure, and bankruptcy rules and
practices. What makes the moment defining is that these
issues are not new—efforts have already been made to
address them within the G-10 countries with mixed suc-
cess, and the need for genuine success is all the greater.
That brings me to Frankel’s second set of issues. I
did not fully understand his arguments, but the issue of the
respective roles of authorities in the G-10 and the emerging
market countries in creating these preconditions is impor-
tant. In my view, there is no question where leadership
should come from. In the context of capital regulation,
leadership from the G-10 countries—rooted in a perspec-
tive that encompasses the emerging market countries—
suggests some considerations in evaluating possible
approaches to twenty-first-century capital requirements. InFRBNY ECONOMIC POLICY REVIEW / OCTOBER 1998 227
particular, we might look for approaches that provide
evolutionary paths for capital requirements, with financial
institutions proceeding along the path at their own
pace and consistent with the nature of their business
strategy and risk management and internal control pro-
cesses. The 1996 Market Risk Amendment to the Basle
Accord, with its standardized and internal models
approaches, represented one example of the creation of an
evolutionary path.
One caution, however. The path concept cannot be
seen as a reason to avoid moving expeditiously down the
path or failing to put the preconditions described by
Frankel in place. When you drive on the Autobahn, you
cannot drive at 25 kilometers per hour or operate a car in
need of repair.
The substantive issues raised by Frankel’s paper are,
what changes to the national and the international financial
systems do we want and how much do we want them? The
other issues he raises—who is a signatory to international
agreements and whether and how to have some interna-
tional enforcement mechanism to ensure minimum
standards among participants in the international financial
markets—are issues of process. We first have to work on
agreeing on the substantive issues. The very process of
forging a consensus is by its nature inclusive, and that
suggests some clear considerations for the process issues. 
The views expressed in this article are those of the author and do not necessarily reflect the position of the Federal Reserve
Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or
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Commentary on 3 papers on the role of capital regulation in bank supervision

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Commentary on 3 papers on the role of capital regulation in bank supervision

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