and structuring offered by banks that may not be as readily available or as cost - effective through the bond market. the higher magnitude and volatility of default rates in these types of borrowers is well documented from decades of experience in the below - investment grade segment of the bond market. consequently, as conditions have weakened and defaults have risen sharply in noninvestment grade bonds, a parallel increase has occurred in troubled and nonperforming loans of bank portfolios. forecasts for a continued rise in defaults for lower rated bonds by moody's suggest that bank corporate asset quality is also likely to deteriorate further before it improves. although part of the deterioration may be a natural consequence of taking normal business risk in a weaker economy, part also reflects a lack of discipline by some banks, particularly in the 1995 - 1997 interval. as banking organizations relaxed their standards and the rigor of their credit risk analysis in this period, banking supervisors responded by issuing cautionary guidance and stepped up the intensity of reviews of lending operations at many banking firms. in particular, supervisors pointed out the need for lenders to avoid the use of overly optimistic assumptions that presumed strong conditions would prevail indefinitely. in addition, supervisors also noted the lack of downside risk analysis or stress testing as a weakness in risk management practices at many banks. recent credit losses have highlighted the importance of following those sound lending and evaluation fundamentals and have clearly differentiated strong credit risk management systems from weak ones, prompting many organizations to take remedial action. for the past several years, the banking agencies have shifted their supervisory approach to focus on risk management processes at banking organizations as a more effective means for promoting sound banking practices. while bank risk management practices have improved, in part because of supervisory efforts, recent experience has shown that more work needs to be done. more recently, to help facilitate improvements underway at banks in response to current credit difficulties, the banking agencies issued guidance earlier this year clarifying their expectations regarding sound practices for managing leveraged finance exposures. even before recent weaknesses, banks had begun to reevaluate their strategic direction and, with the encouragement of supervisors, had become more deliberate about the need to implement formal procedures for recognizing, pricing, and managing risk. without these reforms, the recent deteriorating trends would likely have been considerably worse. in these emerging systems, loans are classified by risk, internal profit centers are charged for equity allocations by risk category, and risk adjustments are explicitly made. in

improving both lending and supervisory policies that we trust will foster better risk management ; but these policies could also reduce the pro - cyclical pattern of easing and tightening of bank lending and accordingly increase bank shareholder values and economic stability. it is not an easy road, but it seems that we are well along it. appendix to testimony of chairman alan greenspan, prepared by staff, board of governors of the federal reserve system the us banking industry is well capitalized and highly profitable by historical standards and in reasonably good shape, although there are signs of erosion as problem loans have risen, especially in larger syndicated credits. moreover, some further erosion is likely as borrowers who have taken on heavy debt burdens experience less robust increases in profits and income than might have been anticipated not too long ago. in many cases, problem loans are a hangover from loans made in the mid - 1990s when lenders evidently failed to exercise sufficient discipline. after about 1998, banks took a number of steps to tighten lending standards and terms, which should help to limit further deterioration. nevertheless, with a weakening economy, problems could well worsen for some banks and some market segments, requiring vigilance by banks and their regulators. as always, the underlying issue is how to adopt and price realistic assessments of likely credit risks under alternative scenarios, keeping credit flowing to worthy borrowers at reasonable prices. today, banking organizations and their supervisors are taking a number of steps that will be necessary to ensure that our financial system continues to flourish and support long - term economic growth well into the future. key elements of such actions are referenced in the last two sections of this appendix. earnings although banking profitability has risen to historically high levels in terms of return on assets and return on equity over the past decade, in recent periods higher loan loss provision expenses and narrowing net interest margins have placed pressures on bank profitability. despite those emerging weaknesses, downside risks likely have been limited by the increasing diversity of noninterest and interest sources of revenues. the continued push by banks to diversify their revenues by expanding business lines devoted to asset management, servicing, securitization, investment banking, and other fee - based activities should help stabilize earnings streams. in addition, in the wake of consolidation and interstate banking, many larger firms are less vulnerable to downturns in particular regions or specialized business lines. nonetheless, in the past few quarters, emerging earnings weaknesses have been pronounced at some of the larger banking organizations, which have experienced sharp increases in loan