Federal Reserve Chairman Alan Greenspan warned yesterday that financial institutions, lulled by the long-running U.S. economic expansion and the large rise in the value of stocks and other assets, may be underestimating the risk that a sudden loss of investor confidence could cause a large drop in those values.
Speaking to an audience of risk managers for such institutions at a Washington conference sponsored by the Office of the Comptroller of the Currency, which oversees nationally chartered banks, Greenspan said they "must be careful not to overlook" the possibility of an across-the-board decline in asset values triggered by such a loss of confidence.
Such a drop, of course, could mean large losses for financial institutions that have made loans or other investments based on an assumption that any decline in asset values would be very limited. In the same vein, the Fed, the comptroller and the Federal Deposit Insurance Corp. all recently cautioned the financial institutions they oversee against making loans that may be justified only on the basis of overly optimistic projections of a borrower's earnings.
In his speech, Greenspan referred to not just a "correction" or a "bubble" in the stock market but a much broader decline in values like the one that followed last year's default by the Russian government on part of its debt. That default so unnerved investors around the world that many financial markets, including the U.S. bond market, "seized up," as Greenspan previously described it.
The Fed chairman highlighted what he called "the perils of risk management" when "periodic crises" undermine the methods institutions use to assess risk. In a financial crisis, both institutional and individual investors dump more risky assets and seek safety in a "fear-induced disengagement." Unfortunately for both investors and institutional risk managers, these crises can't be predicted, he said.
"History tells us that sharp reversals in confidence occur abruptly, most often with little advance notice. These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short period. Panic reactions in the market are characterized by dramatic shifts in behavior that are intended to minimize short-term losses," Greenspan said.
"At a minimum," risk managers need to "stress-test" their methods of evaluating the riskiness of their loans to see what would happen in a crisis "and set aside somewhat higher contingency resources--reserves or capital--to cover the losses that will inevitably emerge from time to time when investors suffer a loss of confidence," he argued.
CAPTION: "History tells us that sharp reversals in confidence occur abruptly," Fed Chairman Alan Greenspan said.