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Testimony of Chairman Alan Greenspan
Condition of the U.S. banking system
Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate
June 20, 2001

Mr. Chairman and members of the Committee, I am pleased to be here this morning to discuss the condition of the U.S. banking system. In my presentation today, I would like to raise just a few issues. I have attached an appendix in which the Federal Reserve Board staff provides far more detail relevant to the purpose of these hearings.

There are, I believe, two salient points to be made about the current state of the banking system. First, many of the traditional quantitative and qualitative indicators suggest that bank asset quality is deteriorating and that supervisors therefore need to be more sensitive to problems at individual banks, both currently and in the months ahead. Some of the credits that were made in earlier periods of optimism--especially syndicated loans--are now under pressure and scrutiny. The softening economy and/or special circumstances have especially affected borrowers in the retail, manufacturing, health care, and telecommunications industries. California utilities, as you know, have also been under particular pressure. All of these, and no doubt other problem areas that are not now foreseeable, require that both bank management and supervisors remain particularly alert to developments.

Second, we are fortunate that our banking system entered this period of weak economic performance in a strong position. After rebuilding capital and liquidity in the early 1990s, followed by several years of post-World War II record profits and very strong loan growth, our banks now have prudent capital and reserve positions. In addition, asset quality was quite good by historical standards before the deterioration began. Moreover, in the last decade, as I will discuss more fully in a moment, banks have improved their risk management and control systems, which we believe may have both strengthened the resultant asset quality and shortened banks' response time to changing economic events. This potential for an improved reaction to cyclical weakness, and better risk management, is being tested by the events of recent quarters and may well be tested further in coming quarters.

We can generalize from these recent events to understand a bit better some relevant patterns in banking, patterns that appear to be changing for the better. The recent weakening in loan quality bears some characteristics typical of traditional relationships of loans to the business cycle--the pro-cyclicality of bank lending practices. The rapid increase in loans, though typical of a normal expansion of the economy, was unusual in that it was associated with more than a decade of uninterrupted economic growth.

As our economy expanded, business and household financing needs increased and projections of future outcomes turned increasingly optimistic. In such a context, the loan officers whose experience counsels that the vast majority of bad loans are made in the latter stages of a business expansion, have had the choice of (1) restraining lending, and presumably losing market share or (2) hoping for repayment of new loans before conditions turn adverse. Given the limited ability to foresee turning points, the competitive pressures led, as has usually been the case, to a deterioration of underlying loan quality as the peak in the economy approached.

Supervisors have had comparable problems. In a rising economy buffeted by competitive banking markets, it is difficult to evaluate the embedded risks in new loans or to be sure that adequate capital is being held. Even if correctly diagnosed, making that supervisory case to bank management can be difficult because, regrettably, incentives for loan officers and managers traditionally have rewarded loan growth, market share, and the profits that derive from booking interest income with, in retrospect, inadequate provisions for possible default. Moreover, credit-risk specialists at banks historically have had difficulty making their case about risk because of their inability to measure and quantify it. At the same time, with debt service current and market risk premiums cyclically low, coupled with the same inability to quantify and measure risk, supervisory criticisms of standards traditionally have been difficult to justify.

When the economy begins to slow and the quality of some booked loans deteriorates, as in the current cycle, loan standards belatedly tighten. New loan applications that earlier would have been judged creditworthy, especially since the applications are now being based on a more cautious economic outlook, are nonetheless rejected, when in retrospect it will doubtless be those loans that would have been the most profitable to the bank.

Such policies are demonstrably not in the best interests of banks' shareholders or the economy. They lead to an unnecessary degree of cyclical volatility in earnings and, as such, to a reduced long-term capitalized value of the bank. More importantly, such policies contribute to increased economic instability.

The last few years have had some of the traditional characteristics I have just described: the substantial easing of terms as the economy improved, the rapid expansion of the loan book, the deterioration of loan quality as the economy slowed, and the cumulative tightening of loan standards.

But this interval has had some interesting characteristics not observed in earlier expansions. First, in the mid-1990s, examiners began to focus on banks' risk-management systems and processes; at the same time, supervisors' observations about softening loan standards came both unusually early in the expansion and were taken more seriously than had often been the case. The turmoil in financial markets in 1998, associated with both the East Asian crisis and the Russian default, also focused bankers' attention on loan quality during the continued expansion in this country. And there was a further induced tightening of standards last year in response to early indications of deteriorating loan quality, months before aggregate growth slowed.

All of this might have been the result of idiosyncratic events from which generalizations should not be made. Perhaps. But at the same time another, more profound development of critical importance had begun: the creation at the larger, more sophisticated banks of an operational loan process with a more or less formal procedure for recognizing, pricing, and managing risk. In these emerging systems, loans are classified by risk, internal profit centers are charged for equity allocations by risk category, and risk adjustments are explicitly made.

In short, the formal measurement and quantification of risk has begun to occur and to be integrated into the loan-making process. This is a sea change--or at least the beginning of one. Formal risk-management systems are designed to reduce the potential for the unintended acceptance of risk and hence should reduce the pro-cyclical behavior that has characterized banking history. But, again, the process has just begun.

The federal banking agencies are trying to generalize and institutionalize this process in the current efforts to reform the Basel Capital Accord. When operational, near the middle of this decade, the revised accord, Basel II, promises to promote not only better risk management over a wider group of banks but also less-intrusive supervision once the risk-management system is validated. It also promises less variability in loan policies over the cycle because of both bank and supervisory focus on formal techniques for managing risk.

In recent years, we have incorporated innovative ideas and accommodated significant change in banking and supervision. Institutions have more ways than ever to compete in providing financial services. Financial innovation has improved the measurement and management of risk and holds substantial promise for much greater gains ahead.

Building on bank practice, we are in the process of improving both lending and supervisory policies that we trust will foster better risk management; but these policies could also reduce the pro-cyclical pattern of easing and tightening of bank lending and accordingly increase bank shareholder values and economic stability. It is not an easy road, but it seems that we are well along it.


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2001 Testimony

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