Former Citigroup Inc. chairman and chief executive officer John S. Reed, speaking in the first of two scheduled lectures at Princeton University, delivered a relatively pessimistic view of the banking industry's ability to manage risk.
Mr. Reed, who retired from Citigroup in April, is a senior visiting fellow at Princeton's Bendheim Center for Finance. Roughly 100 people gathered Monday night to hear Mr. Reed's hourlong talk, "A Retrospective on the Banking Industry, 1965-2000."
Risk managers in the banking industry should assume and plan for the worst by boosting reserves, Mr. Reed said. Risk management tools work well in helping banks get ready to handle potential problems along a relatively narrow continuum, but they are not equipped to deal with big shocks like stock market crashes, currency devaluations, or oil price spikes, he said.
Despite all the time and money invested in improving bank systems, "risk management does not deal with discontinuities" or cataclysmic financial forces that upend the economic status quo, Mr. Reed said.
"I can't find any instance in the literature where the industry has been able to assess the dangers of a discontinuity," he said.
Mr. Reed, who helped assemble the 1998 merger of Citicorp and Travelers Group that created the financial leviathan Citigroup, provided a long list of recent disasters that have disrupted the global economy, including the devaluation of the Mexican peso, the Russian bank crisis, and the slowing of the Asian markets.
Until risk management improves, bankers should develop a "valuation system for dealing with the wreckage after a discontinuity," Mr. Reed said.
They should ask themselves: "If we were to encounter a loss, how would we absorb it?" he said. "Not to avoid a major loss, but rather how to absorb it."
On a global scale, "overall, the banking industry is not in great shape," Mr. Reed said. "The cost of having the banking industry in trouble is immense."
Many banks around the globe, especially those in China, Turkey, Eastern Europe, and Russia, are "relatively fragile," he warned.
Government and industry leaders should invest in better precautionary measures to protect these banks, Mr. Reed said. These steps are far cheaper than the cost of liquidating or resolving failed banks, he said.
"Why society does not seem to comprehend the society's interest in appropriate mechanisms and systems for the banking industry, I don't know," Mr. Reed said. "I don't understand why people don't pay more attention to the robustness of the financial sector."
He also argued that the "bargaining power of the banking sector is relatively weak," and that the "U.S. banking industry has subsidized the private sector" by absorbing risk on behalf of its clients. The failure of banks to price this risk correctly has "eaten" into the sector's earnings, he said.
The industry's "retained earnings are low in comparison to risk absorbed," he said. "We don't do very well in managing risk in the financial sector."
Mr. Reed joined Citicorp in 1965 and ran its technology and operations division and its consumer business divisions before becoming CEO and chairman in 1984.
Citicorp's merger with Travelers was a huge step in the evolution of the financial services business and was a factor in Congress' decision in 1999 to pass the Gramm-Leach-Bliley Act, which allowed banks, insurers, and brokers to own one another.
Mr. Reed's next lecture, scheduled for Feb. 19, will focus on the intersection of technology and finance.