Federal Reserve Board Chairman Alan Greenspan warned Congress Tuesday that loan losses will pile up quickly if the economy stumbles.
"We must be concerned about becoming too complacent about evaluating repayment risk," Mr. Greenspan warned. "All too often, at this stage of the business cycle, the loans that banks extend later make up a disproportionate share of total nonperforming loans."
Testifying before the House Banking Committee's capital markets subcommittee, Mr. Greenspan explained, "Bad loans are made when you experience low yield spreads." Spreads are historically thin, he said, because banks are accepting only "modest" compensation for the risks they are incurring.
He did not quantify the size of margins or how much banks could lose in a downturn.
"The Federal Reserve will make every effort to encourage banks to apply sound underwriting standards in their lending," Mr. Greenspan said. "Prudent lenders should consider a wide range of economic situations in evaluating credit; to do otherwise would risk contributing to potentially disruptive financial problems down the road."
Mr. Greenspan's comments were his strongest yet to Congress on credit quality. The Fed chairman and Comptroller of the Currency Eugene A. Ludwig have been cautioning bankers for three years about loose underwriting standards.
Bankers said they agreed with most of Mr. Greenspan's comments.
"It is a good thing to be calling attention to this," said Paul M. Dorfman, executive vice president at Bank of America and chairman of Robert Morris Associates, the trade group for credit officers. "Lenders are always subject to pressure to keep booking new business and show increased profits. This is a reminder that the environment may not stay benign."
"I'm very concerned with credit quality," said Dorothy M. Horvath, executive vice president at National City Bank, Columbus, Ohio. "Generally we see the worst in the large syndicated credits, but it has trickled down throughout all markets, including the small-business market."
For instance, she said, banks are not adequately stress-testing commercial real estate loans. Instead of testing cash flows by projecting a decline in rental rates or an increase in vacancies, lenders are assuming rents will remain steady in a worst-case scenario, she said.
The Fed chairman also issued another warning on stock prices, although he took pains to avoid categorizing the entire market as overvalued or suffering from "irrational exuberance."
"Quite possibly, 12 or 18 months hence, some of the securities purchased on the market could be looked upon with regret by investors," he said.
Later, in response to questions, he added, "There are values in the system that by historical standards will be hard to maintain."
Mr. Greenspan was on Capitol Hill to deliver his semiannual report to Congress on the country's economic condition. He is to deliver a similar report to the Senate Banking Committee today.
In general, Mr. Greenspan said, the economy gave an "exemplary performance" last year. Gross domestic product rose nearly 4%, the strongest rate in a decade, while unemployment fell to 4.75%, the lowest rate since the 1960s.
Although labor markets remain tight, he said, there is little evidence of price inflation.
Still, the news was not all positive. Rising "storm clouds" from the Asian financial crisis could reduce exports and slow the economy. Mr. Greenspan said the Fed is prepared to alter rates preemptively, but he said the risks are evenly balanced between the need to raise rates to hold growth at a sustainable pace and to cut rates to keep the economy moving.
Finally, the Fed chairman strongly endorsed President Clinton's request for $18 billion of additional financing for the International Monetary Fund. "If we were to cede our role as a world leader, or backslide into protectionist policies, we would threaten the source of much of our own sustained economic growth," he said.
Economists said they saw little sign that the central bank would raise rates when its Federal Open Market Committee meets March 31.
"This wasn't like a quarterback pointing his foot in the direction he is going to throw the ball," said Nicholas S. Perna, chief economist at Fleet Financial Group. "He doesn't know what direction he is going to throw the pass."
"There were relatively few surprises," said Ramachandra Bhagavatula, chief financial economist at Citicorp Securities Inc. "He had already set up the markets to believe that the Fed was not going to do anything in the near term."