Limiting risk has kept banking industry strong

(Editor's Note: The following is excerpted from Federal Reserve Board Chairman Alan Greenspan's remarks at the annual convention of the American Bankers Association, held Oct. 7 in Phoenix.)

I would like to explore the apparent incongruity between the recent substantial losses on corporate credits and the continued strength of the U.S. banking system.

Over the past two or three years, the U.S. financial system has suffered a sharp run-up in corporate bond defaults, business failures, and investor losses.

At commercial banks, troubled loans including charge-offs, classified loans, and delinquent credits have also climbed to quite high levels. At the same time, banks in this country remain quite healthy with strong profits and rates of return and with capital and reserves not much below recent historical highs. Our banks have been able to retain their strength in this business cycle, in contrast to the early 1990s when so many either failed or had near-death experiences.

Why is this? Part of the answer, of course, is that the real economy was different during these two intervals. The most recent recession was less severe and centered mainly in the business sector. After years of rapid growth, capital spending plunged as firms realized that investments in capital goods, especially in the telecommunication and other high-tech sectors, were excessive.

The financing of this high level of spending with debt, which was seen as prudent when equity valuations were high, led to a rise in defaults when firms were no longer able to repay bank loans and other debt through equity issuance in a depressed stock market.

In contrast, despite the substantial destruction of wealth reflected in the decline in equity prices, households, encouraged by ongoing increases in income and housing wealth, have maintained their expenditures.

Low mortgage rates encouraged households to purchase both new and existing homes, the latter enabling sellers to extract large amounts of home equity, previously enhanced by capital gains. Low rates also encouraged refinanced mortgage cash outs and rapid expansion of home equity loans.

Consumer and mortgage loans have not suffered the sharp run-up in delinquencies that loans in the business sector have, and they have contributed significantly to the earnings of the banking system, providing it with the ability to absorb losses elsewhere, to maintain loss reserves, and still to show significant profits.

Those banks with relatively large exposures to the business sector and insufficient offsets from other earning flows were able to avoid stresses because they entered the period with both substantial capital and reserves.

That banks had impressive earnings and balance sheets going into the current period of stress is of key significance. The strong balance sheets lowered funding costs and provided needed buffers.

Some banks also benefited from the increased diversification and scale of their operations that had resulted from previous consolidations.

The larger banks were better able not only to spread their portfolio risks across a wider range of customers, but also to broaden their funding sources.

An analysis of the resiliency of the U.S. banking system would be far from complete without a recognition of the new techniques in risk management that have been applied in banking during the past few years.

To be sure, at most banks the application of these practices has just begun, and even the most advanced banks still have significant strides to make.

Nonetheless, the efforts to quantify risk have provided management with a far more disciplined and structured process for evaluating credits, pricing risk, and deciding which credits to retain. In the process, banks are becoming much less dependent on the analysis and subjective judgments of lending officers.

Although such judgments in the end are indispensable to the lending process, a methodical, systematic and quantitative review of facts including the effects of material new exposures on the lender's consolidated risk provides a greater depth to risk management than we have had in decades past.

Improved risk management and technology have also facilitated, of course, the growth of markets for securitized assets and the emergence of entirely new financial instruments such as credit default swaps and collateralized debt obligations.

Financial derivatives, more generally, have grown at a phenomenal pace in the past 15 years. Conceptual advances in pricing options and other complex financial products, along with improvements in computer and telecommunications technologies, have significantly lowered the costs of, and expanded the opportunities for, hedging risks that were not readily deflected in earlier decades.

Banks appear to have effectively used such instruments to shift a significant part of the risk from their corporate loan portfolios to insurance firms here and abroad, to foreign banks, to pension funds, to hedge and vulture funds, and to other organizations with diffuse long-term liabilities or no liabilities at all.

To be sure, there were, and still are, substantial problems.

Large losses have been taken, and more are yet to be recognized. No risk-management system will ever be flawless, and I emphasize that banks have just begun the process of applying the new quantification techniques.

Let me conclude by noting an often overlooked fact. The use of the more- sophisticated techniques I spoke of earlier, especially the various forms of derivatives, are, by construction, highly leveraged. They are thus prone to induce speculative excesses, not only in the U.S. financial system, but also through out the rest of the world.

The greater potential for systemic risk can be contained by improvements in effective risk management in the private sector, including market discipline based on better public disclosure, and by improvements in bank supervision and regulation in the public sector.

To be sure, as I have noted elsewhere, there is some level of risk that must be absorbed, as a last resort, by central banks if an economy is to obtain the full resource allocation benefits of financial intermediation.