Federal Reserve Board Chairman Alan Greenspan on Friday said banks that trade or use derivatives must do a better job of managing credit risk.
Addressing the Futures Industry Association, Mr. Greenspan said banks should be required to stress-test their derivative holdings for credit risk just as they must test for market risk. Credit risk is the chance that a party will default; market risk is the threat to a portfolio from a sudden change in prices such as interest rates.
"As we approach the 21st century, both banks and nonbanks will need to continually reassess whether their risk management practices have kept pace with their own evolving activities," he said.
Stress testing is especially important because it lets a banker understand how his portfolio might act during extreme market crises, such as the one experienced in the fall when Russia defaulted on its debt, he said.
"Scenario analysis can highlight vulnerabilities to the kind of flights to quality and flights to liquidity that seem increasingly frequent," Mr. Greenspan said.
The Fed chairman said it would be wrong to reject the use of models to set capital requirements just because some failed to perform during the recent global turmoil. Regulators currently let banks with large securities businesses use models to set capital for market risk.
"Some may now argue that the periodic emergence of financial panics implies a need to abandon models-based approaches and return to traditional approaches based on regulatory risk measurement schemes," he said. "This would be a major mistake."
Compared with models, regulatory capital schemes are less accurate and encourage banks to look for the riskiest assets with the lowest capital charges, he said.
"It would be far better to provide incentives to enhance their risk- modeling procedures," he said.
Mr. Greenspan reiterated his opposition to subjecting over-the-counter derivatives trading to regulation by the Commodity Future Trading Commission. He also questioned the need for strict regulation of exchange traded derivatives.
"The fact that the OTC markets function quite effectively without the benefits of the Commodity Exchange Act provides a strong argument for development of a less burdensome regime for exchange-traded financial derivatives," he said.