Management Will Make the Difference

An Interview with Anthony M. Santomero

Nothing grows for 10 years without evolving and changing. Ask any parent, any business owner, any political leader--or any economist. Everything evolves, and economic expansions are no exception." These words were part of an address given to a Delaware organization by Anthony M. Santomero, president of the Federal Reserve Bank of Philadelphia. During his many years as an academician with the Wharton School of the University of Pennsylvania and as an industry consultant, President Santomero has seen lots of evolution, and the industry has always met each new challenge. Determining capital requirements through internal risk ratings is one current challenge that bankers and regulators are working on together. In this interview, President Santomero speaks with Pam Martin, RMA's director of Agency Relations and Communications. He believes the future success of banks depends heavily on successful management.

PM: I don't think there are any readers who would ask the question, "What is the Federal Reserve Bank of Philadelphia?" But how about giving us a brief overview of the bank and what it does?

AMS: The Federal Reserve Bank of Philadelphia supervises banks in most of Pennsylvania, in half of New Jersey, and in Delaware. With about 1.300 employees, the Philadelphia Fed supervises both banks headquartered in this region, such as Commerce Bank, and banks that have branches here. or significant market share, such as First Union. In addition, the bank has a check processing and clearing business. We have $8 to $12 billion in our currency vault at any given time and clear nearly five million checks each day. We also share the responsibility for national monetary policy

As part of our central banking role we invest in research in those areas of banking that are most prevalent for the Third District, for example. consumer credit and credit cards and payments. We have established a payments card center to work on that industry and to understand what is going on both from the point of view of consumer credit and from the point of view of payments activity in general, including the evolution of payments away from paper.

PM: Let's get back to those five million checks per day; we've been hearing for years that we're moving toward a paperless society.

AMS: The truth is that Americans have kept using checks far longer than any other country: on average, Americans use eight times the number of checks that Europeans do and 120 times the number of checks the Japanese use. We have not gone to electronic payments and authorization the way the Europeans have. People have always felt that once electronic payments take off. checks ill decline; but the most reliable estimates I've seen suggest that, in absolute terms, check volume continues to increase about 1-2% each year. The percentage of transactions using checks is declining, however, through use of credit cards, direct deposits, and preauthorizations.

Regardless, checks will remain popular as long as banks offer free or low-cost checking, an option no longer available in most other countries. In addition, we have a far greater number of banks in this country that would have to move to a centralized architecture; this makes it much more difficult. In theory, we could begin to achieve centralized architecture through associations making joint decisions, which is how we got to credit cards. Visa and MasterCard gave us a standard by which to use plastic instead of cash. The ultimate goal, of course, is for the utility company, for example, to send its bill by e-mail with the option, "If you wish to pay this bill now, click here."

The Fed recently announced the first study in 20 years to systematically look at the checking system--the amount of checks used, who uses them, and what they're used for--to figure out where electronics can have a positive effect. We are at a critical transition point, but the demise of the check is way overstated.

PM: Is there any particular focus you bring as president of the Federal Reserve Bank?

AMS: In addition to the bank's area of focus, my personal interest in the risk management area has led the bank toward increased influence in this area. For example, I participate with some colleagues on our supervision and regulatory oversight committee, which is a group of presidents from the regional reserve banks working with the Board of Governors in Washington. I also am chairing the standing committee overseeing our discount window on the credit side of the Federal Reserve. Chairman Greenspan has indicated that area as one in which to look more closely at procedures, and my background seems to conform to that challenge.

In addition, I have the traditional challenges of a bank president, with additional emphasis on the region. The Philadelphia Research Department has for a long time had a strong reputation, which I hope to continue.

PM: Let's talk a little more about your background. You've been in your current position as president of the Federal Reserve Bank of Philadelphia for about a year. Has the transition from your years in academia been difficult?

AMS: I believe my 30 years as an academic and consultant were appropriate training for this job. The Federal Reserve Bank president deals with three areas-central banking and monetary policy, which is my educational foundation; regulatory issues; and payment systems. Over time, I've worked in all three areas. In the late 1970s, for instance, I argued against the primary capital rules and for risk-based capital regulation. I believed then, as I do now, that a generalized raising of capital requirements simply moves the industry toward riskier endeavors. I consulted with a number of central banks, including the Fed, on this issue. This, of course, preceded the 1988 Basel Capital Accord, and today that effort continues to evolve. As far as payments issues are concerned, over time, I've researched and consulted on payments systems both in the U.S. and in a dozen other countries. Quite recently, I was asked to present my views on an international comparison of payments systems at a national conference.

PM: RMA has been very involved in the effort under way to reform the 1988 Basel Accord; a group of banks have been submitting their economic capital numbers and we've had weekly teleconferences to discuss the issues and develop our stance on risk-based capital regulation. The Fed has been driving that process and has worked to get the advanced IRB [internal ratings based] approach into the second iteration of the consultative paper. Have you been involved in that process?

AMS: As an academic and industry participant, I was involved in what makes these things work. At the beginning of the current process, I was asked by the Federal Reserve to go to an early risk-based auditing conference held to help examiners with ways to think about risk management. I talked about how banks think about and perform their own risk-rating and reserves calculation--the aspects that banks cover particularly well, as well as the more ticklish points. I became fairly heavily involved in trading risk issues. At the Wharton School, we brought in a group of bankers who then used the same data with different models and came up with totally different results. This was useful in showing banks that this process is a lot trickier than it appears.

During the two years before joining the Fed, I spent a good deal of time on the credit side. In fact, I co-authored an article that appeared in RMA's Journal on commercial credit valuation, which basically talks about these ratings systems and migration. [1] Within the Fed, my colleague President McDonough of New York, who is also head of the Basel Commission, has spearheaded the move to update these regulations.

PM: RMA is supportive of the effort to make the capital regulation risk sensitive; as the industry continues to evolve, its capital requirements must have a risk-based focus.

AMS: I agree. First, the complexity of the industry and large firms has increased over time. They've had to develop technology and management procedures to evaluate and monitor risk. The regulators would do well to harness that capability and integrate it with their attempts to make sure the industry is safe and sound. That is the essence of the reform process and what Basel seeks to accomplish, and it's a credit to the industry's leaders and to RMA that you are transitioning from a more subjective, qualitative process to more sophisticated analytics that can be used to monitor complex organizations.

PM: Pillar III of the proposed Basel reform calls for greater disclosure to promote market discipline. The Fed in particular has been driving greater disclosure for the past two years, especially for LCBOs [large complex banking organizations].

AMS: Increased transparency allows the market and its participants to react in a much shorter time. It demands of management much more openness; these are useful adjuncts to a more risk-based capital approach.

PM: The theory of disclosure becomes more difficult as it moves to practice, however, because there are no common definitions or standards. For example, "default" has no standard definition within the industry.

AMS: Identifying the problems associated with differences is the first step in solving them, to the extent that we can identify a way of understanding the differences and ways to approach them. Then industry experts will, over time, evolve a common method of looking at things. It's therefore very useful to have far greater openness as the first step, allowing the market to respond to what is going on. As the openness begins, the difficulties of differences and reporting can be sorted out through dialogue between analysts and the industry itself. So I view this not as a roadblock; rather, it's a necessary process in the evolution. You could have said the same thing about any trading system; in time, things evolved to the point that it was possible to understand what everyone was doing and to see what was in the portfolio. The most recent volatility has had remarkably different results on trading portfolios than before, when there were many losses associated with unknown exposures. It's all part of the learning process: to the extent the regulator can assist the industry in evolving in a constructive way, the capabilities of both regulator and the industry are enhanced.

PM: When the first Consultative Paper to reform the 1988 Basel Accord was released in June of 1999, it was thought that perhaps 30 institutions might have the capacity to utilize an internal ratings-based approach for capital allocation; now that number appears to be much higher.

AMS: The question of how many institutions is a tricky one. On an international level, each country presumes it has several institutions with the capability to implement an IRB approach. If you multiply the number of countries by three, you get a fairly large number. And the U.S. has an ongoing discussion--you could even say debate--about the complexity of Basel II and, given its complexity, how many institutions will opt for an IRB approach and how many will not. It's an interesting period of time.

The Basel II working group set out to come up with a proposal that has uniform support. It's the effort toward getting that support that has caused the report to become so big. And each country has a part in the reason behind the size of that report. We hear that the banks that wish to embark on these proposals do so with the anticipation that there will be some benefit beyond just certifying their internal ratings. Institutions are looking at their internal ratings and considering the impact on their capital requirements. If they find their ratings are satisfactory, they are deciding whether or not it pays for them to proceed. Before the original proposal emerged in June 1999, it was not at all clear how complex it would be, and there is nothing to suggest that we can really predict the outcome.

PM: One outcome we've seen from the RMA Working Capital Group is that as the Basel regulations move toward best practice economic capital estimation processes within the industry, the industry itself will, and indeed is, investing in its risk-rating and manage ment capabilities.

AMS: I remember when the Cooke Ratio was first passed in the 1980s. It was developed as a capital adequacy system for banks to cover risks with their own funds--exclusively for the countries that had signed on for it. But many more countries felt that to be progressive they would need to use the Cooke Ratio as well, and soon it became a standard. The fact that there was a standard led banks to try to achieve that standard. Further, by defining a minimum practice, many banks tried to reach beyond the minimum. I think this is very productive.

While the industry reacts to each new bench mark, however, we must keep in mind that the benchmarks are derived from the evolution of industry practice itself. If we had proposed an IRB approach five years ago, the industry would not have been advanced enough with models and risk migrations to embrace the idea. But now that the industry has progressed to the point that such an approach is feasible, they also can measure themselves against a defined practice, whether or not it is the "best" practice. Relatively sophisticated players--mind you, not necessarily the biggest--in the market will say, "Yes, we can do that." When interest rate risk quantification/management methods were first available in the 1960s, people felt it was too hard to do gap analysis. Now, gap management is considered a sophomore problem. We've come a long way since then, and now the industry is working in concert with the regulatory agencies.

PM: Your background has certainly prepared you well to help in this process.

AMS: I believe that's true. This is certainly a complex regulatory environment--both domestically and inter nationally. But as opportunities arise, I try to bring to bear my understanding of the realities of the institutions and the capabilities of the new technologies.

PM: You've written extensively about financial modernization legislation. Now that it is a reality, have there been any surprises to industry response to the repeal of Glass-Steagall?

AMS: Prior to the passage of the Gramm-Leach-Bliley Act, the debate in Washington was over a fundamental question: Given the way the industry has evolved around Glass-Steagall, how important is the explicit repeal of the Act? The general consensus is that modernization and rationalization of the regulatory structure associated with financial modernization makes sense. But if that first debate has validity, people will be slow to take advantage of GLBA because banks have not perceived any huge breakthrough. As opportunities develop, banks will seize them and put in structures as appropriate.

Those who thought of the Act as startlingly new expected dramatic changes and dramatic announcements. In fact, if you look at the data, you'll find that most activity is at medium-sized institutions--financial holding companies that may have several banks. In an environment of healthy institutions with a good amount of capital, many of these banks view GLBA as an opportunity for a little added flexibility, such as some insurance, brokerage, and mutual fund activities. While well capitalized, they reason, why not take the opportunity to get the certification, and then use it slowly over time? And they've done exactly that.

The larger institutions have been slower, because they've seen fewer opportunities. I'm not surprised that most institutions will enter new activities only when a given activity seems appropriate. So I believe you'll see a consistent move in this direction but not a startlingly fast one.

PM: The repeal of Glass-Steagall occurred in very good economic times, when many institutions were at peak earnings and had strong capital positions. Do you have any concerns about the impact of a slower economy and problem loans on this new diversification of products and services?

AMS: Your point is well taken. However, remember that the activities that have been allowed by GLBA are, by design, financial. The activities are neither good nor bad in themselves; rather, they represent a challenge to be managed effectively. There are plenty of opportunities for a simple bank structure to take risk, and there are plenty of opportunities for a complex bank holding company to take risk. The challenge for management is to manage those risks prudently. My expectation is that to the extent that they do so, these new lines will be profitable. But it will require a commitment to managing the financial holding company with the same rigor and integrity as the bank itself.

PM: Is it possible that GLBA could lead some banks to believe they are diversifying when in fact they are not, and that they will be caught in the age-old trap of being overly concentrated?

AMS: That's a good question. It goes to the heart of knowing how to pick the businesses banks will be in. The logical activity of bank management is to stay with what they know, which means they will diversify into similar areas. So while they think they are diversifying, it's like saying, "I'm going to expand from first mortgages into second mortgages." In some respects you can justify a firm that specializes in, for example, wholesale credit going into underwriting or placement of commercial paper as a similar business area. Going from private banking into investment management is a similar situation. On the other hand, these are businesses that have related cycles. So when managers look at areas of expansion, they must look at two opposing forces:

1. The expertise and understanding they bring to that business.

2. The nature of the correlation of those businesses.

Frequently, in the early days of deregulation and diversification, financial executives forgot number one. They went into businesses they could get into but had no particular expertise in. They found out later that they had losses outside their knowledge base-the savings-and-loan industry being the most acute example. But the financial industry is not alone. It also occurred in the industrial sector of the economy, where you later saw spin-offs of unrelated businesses. We then moved into a period of consolidation, which made sense from a customer or distribution standpoint. But this is a bit of a concentration play rather than a move toward broad diversification. Even though you may have lots of businesses, they all are subject to the same uncertainties and risks.

The challenge is to recognize the relationship of these risks. This is why enterprise-wide risk management and sound and effective management information systems are an essential ingredient in any expansion of activity.

PM: Diversification should be beneficial, strengthening the system.

AMS: Diversified sources of income do add a degree of stability. The issue for a financial holding company is to recognize that diversity also has a challenge of management. Banks should not collect new lines of business randomly; each should make sense. As the activities expand, the challenge for management is to learn which do and which do not present any particular advantage or value. The result will be financial institutions with similar charters but that do very different things--and that's good. They will have to answer where they fit into the financial landscape.

Some banks may overly concentrate in one product line, one focus, or one customer group. Their answer to any expressed concern is that they understand the line, the focus, or the customer group very well and can manage it effectively. On the other hand, other firms may evolve quite differently--say, bringing in a wholesale line to a retail operation; the challenge there is to have the know-how to manage this new line.

In the old days of local franchises and simple product lines, the balance sheet explained the bank's vulnerabilities. In a world as open and diverse as ours today, the real question is whether management has the know-how and systems in place to manage the risks of these various businesses.

So the management challenges are the critical ones. The supervisory challenge is to try to verify the management capability. This fits right into the trend of risk-based exams, because it comes right to the heart of the fact that it's not the contents of the balance sheet but having the systems set up to manage the various parts of the balance sheet. And the supervisor must invest in understanding these issues; that's why supervisors have been pushing quite hard to get the right people and capabilities. To examine internal models, supervisors must know what the models are and how they work. Then the supervisor can go into the bank to ask how they are being implemented and certify the process. That's a considerable escalation in responsibility. Again, the same problems existed and were overcome in trading risk.

PM: Pulling on your background in economics, your time spent in academia and consulting, and your cur rent position as regulator, what are your immediate (next six months) and long-term views of the industry?

AMS: We've seen how a combination of an economic expansion, diversity of revenue sources, continued focus on risk and capital management techniques, and expense control have contributed to sound industry performance. Right now we are seeing the impact of a slowdown and some pressure on earnings in the industry. Over the next six months I believe we will see the industry working through an evaluation of its loan portfolio, looking for weakness or vulnerability in some specific sectors as a result of the economic slowdown. Overall, the banking industry is well positioned to do this, with good capital and dramatically improved risk systems making for a healthy prognosis going forward.

PM: What are some steps banks of all sizes should be taking now to ensure the best future?

AMS: The most important challenge for bank management is to ensure that the bank's earnings and risks are managed properly and prudently. In addition, banks will find themselves increasingly emphasizing marketing and customer needs in an effort to attract and maintain the most valuable customer segments.

PM: What are the most worrisome problems you see on the horizon?

AMS: Clearly, the major challenge bankers are confronting is the continuous need to change. New competitors, new regulation, and new technologies in the financial services market require constant focusing and refocusing. I'd call it "wearisome," rather than "worrisome." As we look toward the horizon, strategy becomes more important for an industry in transition and transformation. In many respects, we are living Alvin Toffler's Future Shock.

PM: What advice would you offer an ambitious young banker today?

AMS: I'd start by saying the business of banking offers ambitious bankers an array of exciting and varied career opportunities. As the industry continues to change and evolve, it will require bankers to find innovative ways of funding, delivering, and marketing financial services. Bankers also have to look at how to use technology effectively and manage the additional risks associated with it.

To compete in an industry that is becoming increasing analytical, I would encourage bankers to understand the numbers and to be comfortable with them. But they should never lose sight of their customers' requirements and they should never stop trying to satisfy them.

Notes

(1.) Scott D. Aguais and Anthony M. Santomero, "Incorporating New Fixed Income Approaches into Commercial Loan Valuation," The Journal of Lending & Credit Risk Management, February 1998, pp. 58-65.

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