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Greenspan urges banks to rely on risk management to control bad loans

Updated:
WASHINGTON (AP) _ Federal Reserve Chairman Alan Greenspan said Friday that commercial banks and banking regulators need to rely more on the emerging field of risk management to control loan defaults during periods of economic weakness.

Greenspan said it was only human nature for banks to get overconfident about their lending practices during boom times and then to sharply retreat from making loans when the economy weakens.

``To the majority of banks, the environment of contagious optimism makes more and more proposals seem bankable'' during times of prosperity, Greenspan said. And on the other side of the ledger, when the economy begins to weaken, banks and their regulators will overreact, he said.

In response to questions, Greenspan told his audience at a banking conference in Chicago that the long-term outlook for the economy is ``increasingly, persuasively good'' even though the short-term prospects for a rebound in business investment are still ``rather mixed.''

Greenspan said the huge increases in Americans' productivity in recent months _ including an 8.6 percent surge in the first quarter _ overstated gains in this important measure of living standards. But he said he is convinced that worker productivity has improved significantly since 1995 after more than two decades of lackluster gains.

``Something is going on,'' Greenspan said. ``At a minimum, it is confirming that the shift in growth of the rate of productivity subsequent to 1994 is real.''

In his remarks to the banking conference, Greenspan said it was natural for bankers to grow more cautious in their lending practices during bad times.

``As the economy deteriorates, fewer projects seem attractive as more of the previously extended credits become nonperforming. Cautious voices, including those of the supervisors, become prominent,'' Greenspan said.

To help moderate this boom-bust cycle of banking, Greenspan said banks and their regulators should rely more on risk management in which banks use sophisticated computer models to help them assess the relative risks of their loans.

This is especially important, Greenspan said, because in the last 20 years the average quality of commercial banks' loan portfolios has declined as high-quality borrowers have been able to raise much of the money they need by issuing their own bonds.

For large banks, Greenspan said, ``The loss of their highest-quality borrowers has elevated the aggregate risks in their portfolios.''

Because of this, he said, the biggest banks have been pioneers in the new field of employing various risk-management techniques to constantly monitor the loans they are making.

He said this development is giving increased power to a bank's risk control officers over the bank's lending officers, whose job it is to make loans to generate more business for the institution.

``Better ability to quantify risk has begun to give the risk manager new authority in the credit-granting process,'' Greenspan said.

Greenspan stressed that all computer models to assess risk are based on uncertain forecasts about what will happen to the economy.

``Nonetheless, with all their limitations, formal risk management models are essential in providing a consistent analytic framework for collecting, organizing and summarizing information ... so the bank managers and bank examiners can assess the institution's overall risk profile in a rational and comprehensive manner,'' Greenspan said.

He said this was at the heart of the international effort to come up with new banking standards, known as the Basel Capital Accord.

He said this effort, while taking longer than expected, will serve as an important guide that will allow banking regulators in the United States and other countries to make informed judgments about loan risks, especially at the world's largest banks.
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