Supervision by Risk and Minsky's Proposal for a Cash Flow-Oriented Bank Examination

In recent statements, federal bank regulators from the OCC, FDIC, the Board of Governors of the Federal Reserve and Federal Reserve Banks have called for a new approach to bank examinations. The essence of the new approach to bank examinations is what Comptroller of the Currency Eugene Ludwig calls “supervision by risk,” i.e., exams which focus on evaluating the quantity of risk exposure in an institution and determining the quality of the risk management systems in place to control that risk. Taking a similar approach, Ricki Helfer, Chairman of the FDIC notes, the exam focus will be more of a macroeconomic approach and will include the increased involvement of economists in the bank examination process. Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System, has stated that regulatory innovation is necessary and that the Board has been studying an alternative capital allocation approach which he calls the “pre-commitment approach.” This would allow banks to choose their own capital allocations for trading risk that they believe are consistent with their own risk management capabilities. These discussions of new approaches to bank examination echo some of the concerns put forward in a proposal three decades ago by Hyman Minsky for a “cash flow-oriented” bank examination. Though Minsky spent his career as an academic, his working relationship with private banks and federal bank regulatory agencies gave him unique insights into the workings of the financial system. Minsky based his bank examination proposal on his analysis of the problem of financial instability, and though his writings on financial instability and the macroeconomy are well known, especially by economists in the Post-Keynesian, Marxian, and Institutionalist traditions, however his proposal for reform of bank examination is virtually unknown