The U.S. banking system has been “undercapitalized” for the past “40 to 50 years,” former Federal Reserve Chairman Alan Greenspan told a panel today in Washington convened to investigate the roots of the financial crisis.
In response to a question about the Fed’s failure to guard against megabanks becoming so large and interconnected that they posed a systemic risk — risks that pose threats to the entire financial system — Greenspan said the Fed wasn’t alone in that regard.
Rather, he said, everyone — the financial industry and their regulators at the Fed — failed to appropriately appreciate how badly banks were guarding themselves against risk.
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Once the Fed realized how poorly the banks’ risk management systems were, Greenspan realized how poorly they were capitalized — money, in short, that banks keep on hand to protect themselves from going under in the case of huge losses.
In fact, the banking system has been “undercapitalized” for the past “40 to 50 years,” he said.
Put another way: for the past few generations, the U.S. banking system has not been holding enough money to guard itself from insolvency, putting taxpayers at great risk in case a panic were to materialize — a lesson painfully learned in 2008.
When regulators judge banks to be undercapitalized, the banks are told to shore up their capital or shed potential sources of future losses, like sour loans or underperforming businesses. If they can’t, they’re shut down. Most of the time, it’s an open-and-shut case.
“The risk management paradigm nonetheless harbored a fatal flaw. In the growing state of euphoria, managers at financial institutions, along with regulators including but
not limited to the Federal Reserve, failed to fully comprehend the underlying size, length, and potential impact of the so-called negative tail of the distribution of risk outcomes that was about to be revealed as the post-Lehman Brothers crisis played out,” Greenspan said in his prepared remarks.