Federal Reserve Board Chairman Alan Greenspan cautioned banking regulators Thursday not to become overly rigid in evaluating banks' efforts to manage risk.
While firmly endorsing the new supervisory focus on risk management, Mr. Greenspan expressed concern that examiners could get carried away and require banks to eliminate all risk.
"The purpose of risk management is not to eliminate risk, but to manage it in a prudent way," Mr. Greenspan said in a speech to the International Conference of Banking Supervisors in Stockholm. A text of his remarks was released in Washington.
Mr. Greenspan's speech marks the first time that a top banking regulator has voiced worries that the scrutiny of banks' risk management could backfire.
During the past year, examiners at the Fed, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp. have pushing their examiners to look beyond credit quality to consider a broader array of risks. The Fed has pinpointed five additional categories: legal, liquidity, reputation, operational, and market.
And plans are under way to incorporate assessments of risk management programs into the formal ratings that these supervisors assign to banks upon completion of an exam.
In his speech Thursday, Mr. Greenspan said regulators must let banks take chances, even it if leads to some failures. Risk is how banks make money and how they meet the credit needs of their communities, he said.
"We must be assured that, with rare and circumscribed exceptions, we do not substitute supervisory judgment for management decisions," Mr. Greenspan said. "That is the road to moral hazard and inefficient bank management."
Industry observers said they were encouraged by Mr. Greenspan's remarks.
"It demonstrates to the industry that the agencies are not wholly unaware that if banks don't take risks, they are not viable," said Karen Shaw Petrou, president of the industry consulting firm ISD-Shaw Inc.
Paul Allan Schott, national director of bank regulatory services for Coopers & Lybrand, said bankers are worried that examiners will criticize them for not using risk management systems to eliminate all threats to the institution.
"This is most definitely a concern," Mr. Schott said. "A bank may be criticized without proper justification for its risk management approach."
Not that risk management isn't important. Mr. Greenspan said strong internal controls are the best defense against bank failures. He noted that Barings Bank didn't collapse because a trader bet the wrong way on the Japanese stock market. Rather, it failed because the bank did not have adequate controls in place to supervise the trader.
Senior bank management and members of the board of directors must play central roles in any risk management system, he said.
Supervisors should ensure that banks extend internal controls and risk- management policies to all of their offices around the world, he added. Also, regulators in various countries must share information.
"Coordination and cooperation between home and host countries become not only important, but essential in maintaining financially sound institutions and financial markets," he said.
Mr. Greenspan also said regulators must adapt to changes in technology, which permit banks to design more complex financial instruments. "A generation ago, a month-old bank balance sheet was a reasonable approximation of the current state of an institution," he said. "Today, for some banks, day-old balance sheets are on the edge of obsolescence. In the 21st century, that will be true of most banks."
Regulators have made strides, he said. The new market-risk proposal, which would permit banks to use internal models to set their capital levels, show supervisors are trying to keep up, he said.
Supervisors will get some help from market analysts and investors, who can use new technology to keep better tabs on banks. "We must be careful not to impede the process," he said.
