For release: Sept. 28, 2004

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Supervisors Must Put Greater Emphasis on Exposure to Market Risk and Risk Management Systems: St. Louis Fed Analysis

St. Louis.— As U.S. banks continue their evolution from providers of traditional services to providers of complex risk-management services, bank supervisors will have to adjust to the growing dominance of these more complex institutions.

That's the evaluation of Klimentina Poposka, an assistant researcher in monetary and credit policy at the Institute of Economics, St. Cyril and Methodious University in Skopje, Macedonia; Mark D. Vaughan, an economist and assistant vice president of the Federal Reserve Bank of St. Louis; and Timothy J. Yeager, an economist and senior manager with the St. Louis Fed. Their comments appear in the October issue of The Regional Economist, the St. Louis Fed's quarterly publication of business and economic issues.

Popksa, Vaughan and Yeager identified the two prevailing views as to where the U.S. banking industry is heading:

1. a long-term state of decline, with the supply of traditional deposits shrinking as households turn from checking accounts to cash-management accounts, and from savings accounts to mutual funds; or
2. a cusp of unprecedented growth and innovation, with more complex services and derivative intermediation.

Which is true?

To help answer that question, Poposka, Vaughan and Yeager categorize each U.S. bank as one that primarily engages in traditional activities, or as one that primarily engages in complex risk management. Extracting key information from the bank's financial reports, the researchers focused on four elements: asset size, geographical diversity, fee income and derivatives activity.

"Nearly all banks exhibit some degree of both traditional and complex services," they said.
They emphasized that it's well-known that just a few organizations hold the majority of assets in the U.S. banking industry. Consequently, Poposka, Vaughan and Yeager considered banks with more than $10 billion in assets as eligible to be "complex." Their research indicates that 62 banks met that criterion in 1993, while 67 banks met the criterion 10 years later and that these banks held just over 79 percent of industry assets.

Poposka, Vaughan and Yeager also asserted that:

• Traditional banks commonly conduct business in a single geographic area.

• Banks that engage in significant service and risk intermediation earn relatively more fee income than banks that engage primarily in making loans.

• Derivatives activity is a strong signal that a bank is selling complex risk transfer services. Despite the explosion in this activity, however, they note that surprisingly few banks engage in it, with the top five users of interest rate derivatives accounting for more than 93 percent of the market.

Their research shows that by the end of the 10-year period, the number of traditional banks had declined by more than 1,800 and that their share of industry assets dropped nearly 27 percentage points.

"Clearly," Poposka, Vaughan and Yeager said, "the industry is evolving from one engaged primarily in traditional activities to one engaged in complex risk intermediation. This is not to say that traditional banking will disappear, however. In fact, traditional banking remains extremely viable, as illustrated by the high earnings posted by banks of all shapes and sizes over the past decade."

Poposka, Vaughan and Yeager concluded that bank supervisors will have to continue to adjust for the growing dominance of complex banks by "putting less emphasis on supervising asset quality and more emphasis on supervising exposure to market risk and risk management systems."

The Regional Economist is also available on the St. Louis Fed’s web site: www.stlouisfed.org.

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve Banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, and provides payment services to financial institutions and the U.S. government.

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