alan greenspan : cyclicality and banking regulation remarks by mr alan greenspan, chairman of the board of governors of the us federal reserve system, at the conference on bank structure and competition, federal reserve bank of chicago, chicago, illinois, 10 may 2002. * * * my congratulations to mike moskow and his colleagues for once again designing and implementing an excellent and topical program, with some very interesting papers. the theme of the conference - financial market behavior and appropriate regulation over the business cycle - - could not be more relevant for a group of central and commercial bankers, not to mention our academic friends. to be sure, there are those that believe that a regulation should be considered totally independently of either current business conditions or the regulation's implications for financial markets. this position is predicated on the view that the reason for the regulation - - in the case of financial markets, usually prudential behavior, consumer protection, or community reinvestment - - is an end in itself and should require that macro policymakers adjust to the regulation. indeed, some of what we do is that. but our emphasis today is the need to be sensitive to the market and cyclical implications of the regulations we adopt. the conference theme does not imply cyclical effects or market responses should dominate the decision about applying a rule that may be needed for other purposes. rather, our assignment at this conference is to consider, as part of the policymaking and evaluation process, the joint implications of our regulatory - - and, i should add, our supervisory - - policies both for their intended purposes and for financial markets and cyclical stability. cyclicality in financial markets and intermediation financial markets and intermediaries are part of the macroeconomic cyclical process, and thus new rules involving these markets and institutions need to be evaluated in that context. this is an important reason, in my judgment, why central banks in general, and the federal reserve in particular, should remain in the bank regulatory business. it is evident that regulatory rules can add to ongoing macroeconomic and asset - quality cyclicality. rules are constraints or limits that require responses as those limits are approached. sometimes those limits - - say capital constraints - - may induce tighter lending standards or shrinking balance sheets for a number of institutions at the same time, engendering significant real business - cycle effects. we must, therefore, be aware of the implications beyond the original intent of a rule and consider its associated tradeoffs. government programs, too, often

of factors, especially local and regional developments. in an integrated economy like ours, small bank lenders are affected by national business conditions, just less so than lenders to large firms. formal risk management in banking the large institutions, with their declining overall asset quality, understandably have pioneered more - formal risk - management techniques designed to capture quantitatively the changing riskiness of exposures and presumably induce more rapid responses to such measures. this is the latest development in a changing balance of power between lending officers and risk - control officers. the lending officers, in a competitive economy, may tend to be more interested in getting business than in evaluating risk. before the most recent period, risk officers often have not been heard clearly enough and early enough, perhaps because they have not had the quantitative justification for rejecting weak credits until it is too late. the revolution in credit - risk management, a revolution that is still in process i might add, is the growing ability to measure risk. better ability to quantify risk has begun to give the risk manager new authority in the credit - granting process. it has also given the credit risk manager the ability to make the case for absolute and relative riskiness even during periods of expansion and optimism. making such a case may not necessarily reduce credit availability at banks for riskier borrowers ; it does mean that banks can more knowingly choose their risk profiles and price that risk accordingly. supervisors using such techniques - leveraging off the banks'measures of risk - - can also better evaluate the risk taken by banks relative to the banks'control systems and capital positions, and respond accordingly. and evident increasing transparency will let uninsured creditors, especially subordinated debenture holders, also leverage off the banks'improved risk measures, bringing to bear additional market discipline and hence enhanced risk oversight by counterparty. perhaps more critically, better risk management and the associated quantification have the real potential for reducing the wide attitudinal swings that are associated with the historical cyclical pattern in bank credit availability to which i referred earlier. formal procedures for quantifying credit risk as an integral part of the operational loan process imply - - and in the long run, virtually ensure - - a process for recognizing, pricing, and managing risk. risk quantification should lead to tighter controls and assigned responsibilities. the risk effects of lending officers'decisions can be recognized in a more timely fashion, thus reducing the cyclical attitudinal swings in banking. i would like to