VOLUME 84 I] NUMBER 11 U NOVEMBER 1998 FEDERAL RESERVE BULLETIN BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, WASHINGTON, D.C. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Table of Contents 897 CREDIT RISK RATING AT LARGE U.S. benefits would be financed, as they are not under BANKS present law. (Testimony before the Senate Com- mittee on Finance, September 9, 1998.) Large banks use internally developed credit rat- ing systems to differentiate the riskiness of their 926 Alan Greenspan, Chairman, Board of Gover- commercial loans. Internal ratings are an essen- nors, discusses the recent problems in the inter- tial ingredient of effective credit risk manage- national financial system and testifies that par- ment for such banks, whose commercial borrow- ticipation in the international financial system, ers may number in the tens of thousands. This with all its benefits, carries with it an obligation article describes these rating systems, how their to maintain a level of stability and a set of strong design varies across institutions, and how they and transparent institutions and rules if an econ- are used in risk management. The article also omy is to participate safely and effectively in outlines conceptual and practical difficulties cur- markets that have become highly sensitive to rently faced by banks in achieving accurate and misallocation of capital and other policy errors. consistent ratings and describes ways in which Chairman Greenspan states further that the con- some institutions have attempted to deal with ditions that should be met before engaging in these difficulties. This article is based on a de- international borrowing need to be promulgated tailed review of policy documents and internal and better monitored by domestic regulatory management reports from the fifty largest U.S. authorities. (Testimony before the House Com- bank holding companies and interviews by the mittee on Banking and Financial Services, Sep- authors at a selection of these institutions. tember 16, 1998.) 929 Edward W. Kelley, Jr., member, Board of Gover- 922 INDUSTRIAL PRODUCTION AND CAPACITY nors, discusses the Year 2000 issue and testifies UTILIZATION FOR SEPTEMBER 1998 that the Federal Reserve has completed the reno- Industrial production, which had rebounded vation of its mission-critical systems and is near- 1.6 percent in August after settlement of the ing the conclusion of internal Year 2000 testing strikes at key General Motors plants, declined efforts. Governor Kelley further states that the 0.3 percent in September, to 128.7 percent of its Federal Reserve is committed to a rigorous pro- 1992 average. Capacity utilization fell 0.5 per- gram of industry testing and contingency plan- centage point in September, to 81.1 percent, ning and, through its supervisory initiatives, to 1.0 percentage point below its 1967-97 average. identifying those organizations that most need to apply additional attention to Year 2000 readi- 925 STATEMENTS TO THE CONGRESS ness. (Testimony before the House Committee on Banking and Financial Services, Septem- Edward M. Gramlich, member, Board of Gover- ber 17, 1998.) nors, testifies on social security reform as past chair of the 1994-96 Quadrennial Advisory 936 Chairman Greenspan testifies that, with few Council on Social Security and stresses the signs that the financial crisis that started in Asia importance of two goals: The first is to make last year has subsided, or is about to do so, affordable the important social protections of policymakers around the world have to be espe- this program, and the second is to add new cially sensitive to the deepening signs of global national saving for retirement. Governor Gram- distress, which can impact their own economies. lich further states that the social security and Chairman Greenspan further states that improve- pension changes that he has recommended ments in transparency, in commercial and legal would mean that approximately the scheduled structures, as well as in supervision cannot be level of benefits would be paid to all wage implemented quickly and that accordingly the classes of workers, of all ages, and that these current crisis will have to be addressed with Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ad hoc remedies. (Testimony before the Senate Al FINANCIAL AND BUSINESS STATISTICS Committee on the Budget, September 23, 1998.) These tables reflect data available as of September 28, 1998. 939 ANNOUNCEMENTS Easing of the stance of monetary policy by the A3 GUIDE TO TABULAR PRESENTATION Federal Open Market Committee. A4 Domestic Financial Statistics Tentative schedule for meetings of the Federal A42 Domestic Nonfinancial Statistics Open Market Committee. A50 International Statistics Meeting of the Consumer Advisory Council. A63 GUIDE TO STATISTICAL RELEASES AND Amendment to Regulation C. SPECIAL TABLES Amendments to Regulation E, Regulation DD, A76 INDEX TO STATISTICAL TABLES and Regulation M. Issuance of a supervisory letter on internal credit A78 BOARD OF GOVERNORS AND STAFF rating systems. A80 FEDERAL OPEN MARKET COMMITTEE AND Issuance by the Basle Committee of a paper on internal control systems. STAFF; ADVISORY COUNCILS Issuance by the Basle Committee of papers on risk-management standards in banks. A82 FEDERAL RESERVE BOARD PUBLICATIONS Statement by Chairman Greenspan on the nomi- A84 MAPS OF THE FEDERAL RESERVE SYSTEM nation of Edwin M. Truman as Assistant Secre- tary of the Treasury for International Affairs. A86 FEDERAL RESERVE BANKS, BRANCHES, Changes in Board staff. AND OFFICES 943 LEGAL DEVELOPMENTS Various bank holding company, bank service corporation, and bank merger orders; and pend- ing cases. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis PUBLICATIONS COMMITTEE Lynn S. Fox, Chairman f ' S. David Frost P Karen H. Johnson "~i Donald L. Kohn ,J J. Virgil Mattingly, Jr. i"J Michael J. Prell "1 Dolores S. Smith i ' Richard Spillenkothen The Federal Reserve Bulletin is issued monthly under (he direction of the staff publications committee. This committee is responsible for opinions expressed except in official statements and signed articles, ll is assisted by the Economic Editing Section headed by S. Ellen Dykes, the Multimedia Technologies Center under the direction of Christine S. Griffith, and Publications Services supervised by Linda C. Kyles. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Credit Risk Rating at Large U.S. Banks William F. Treacy, of the Board's Division of Banking neously consider many risk factors for each of the Supervision and Regulation, and Mark S. Carey, of many borrowers. Most large banks use ratings in one the Board's Division of Research and Statistics, pre- or more key areas of risk management that involve pared this article. credit, such as guiding the loan origination process, portfolio monitoring and management reporting, Internal credit ratings are becoming increasingly im- analysis of the adequacy of loan loss reserves or portant in credit risk management at large U.S. banks. capital, profitability and loan pricing analysis, and as Banks' internal ratings are somewhat like ratings inputs to formal portfolio risk management models. produced by Moody's, Standard & Poor's, and other Banks typically produce ratings only for business and public rating agencies in that they summarize the risk institutional loans and counterparties, not for con- of loss due to failure by a given borrower to pay as sumer loans or other assets. promised.1 However, banks' rating systems differ In short, risk ratings are the primary summary significantly from those of the agencies (and from indicator of risk for banks' individual credit expo- each other) in architecture and operating design as sures. They both shape and reflect the nature of credit well as in the uses to which ratings are put. One decisions that banks make daily. Understanding how reason for these differences is that banks' ratings are rating systems are conceptualized, designed, oper- assigned by bank personnel and are usually not ated, and used in risk management is thus essential to revealed to outsiders.2 understanding how banks perform their business For large banks, whose commercial borrowers may lending function and how they choose to control risk number in the tens of thousands, internal ratings are exposures.4 an essential ingredient in effective credit risk manage- The specifics of internal rating system architecture ment.3 Without the distillation of information that and operation differ substantially across banks. The ratings represent, any comparison of the risk posed number of grades and the risk associated with by such a large number of borrowers would be each grade vary across institutions, as do decisions extremely difficult because of the need to simulta- about who assigns ratings and about the manner in which rating assignments are reviewed. In general, in designing rating systems, bank management must 1. For example, bonds rated Aaa on Moody's scale or AAA on weigh numerous considerations, including cost, effi- Standard & Poor's scale pose negligible risk of loss in the short to medium term, whereas those rated Caa or CCC are quite risky. ciency of information gathering, consistency of rat- 2. For additional information about the internal rating systems of ings produced, staff incentives, the nature of the large and smaller banks, see Thomas F. Brady, William B. English, and William R. Nelson, "Recent Changes to the Federal Reserve's bank's business, and the uses to be made of internal Survey of Terms of Business Lending," Federal Reserve Bulletin, ratings. vol. 84 (August 1998), pp. 604-15; see also William B. English and A central theme of this article is that, to a consider- William R. Nelson, "Bank Risk Rating of Business Loans" (Board of Governors of the Federal Reserve System, April 1998). able extent, variations across banks are an example of For information about the rating systems of large banks and about form following function.