Risk managers leapfrog lending officers in bank hierarchy, says Greenspan

“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,” said Greenspan during a speech late last week in Chicago.

The decline in overall asset quality led large banks to pioneer more formal risk management techniques. “[These are] designed to capture quantitatively the changing riskiness of exposures and presumably induce more rapid responses to such measures,” Greenspan said.

He stressed the vital importance risk management will play in enhancing the long-term value of banking loan books, adding that prudent risk management aligns the incentives of lending officers with regulators’ desire for reduced cyclicality.

But Greenspan voiced reservations about the limitations of risk models. “Risk management strategies rest on uncertain forecasts and that the models underlying the frontier approaches depend on key assumptions that rest on fragmentary or indirect evidence.”

He cited covariance matrixes as an example of backward-looking practices that presume historical relationships among risk drivers will continue into the future.

“Similarly, the distributions of credit default and loss probability are notoriously difficult to estimate and validate, especially given relatively short data histories, and so tend to be guided as much by judgmental assumptions as by empirical analysis,” said Greenspan.

But he added that risk models are an effective, perhaps essential, means to organise and enhance risk management judgment.

Supervisors are attempting to make this analytical framework the basis of the new risk-sensitive Basel II capital Accord. Greenspan said national supervisors should be required to validate each bank’s risk classification and risk management system.

“Negotiators in Basel continue to fine-tune the proposed Accord in ways that promise to damp cyclical swings in capital requirements relative to what was implied by last year’s proposal,” the Fed chairman added.