WASHINGTON -- Alan Greenspan, the chairman of the Federal Reserve, outlined the state of the banking industry in an appearance yesterday before the U.S. Senate Committee on Banking, Housing and Urban Affairs. Here is the full text of Greenspan's opening statement:Chairman Shelby, Senator Sarbanes, and members of the committee, I am pleased to be here this morning to discuss the condition of the U.S. banking system and various related matters. They include improved risk-management practices of banks, the current status and direction of our regulatory efforts to revise capital standards for internationally active banks, deposit insurance, and the ongoing consolidation process within our domestic banking industry. Growth in the size and complexity of the largest U.S. and foreign banking organizations, in particular, has substantially affected financial markets and the supervisory and regulatory practices of the Federal Reserve and other bank regulatory agencies around the world. It has, in part, required authorities to focus more than before on the internal processes and controls of these institutions and on their ability to manage risk. Only through steady and continued progress in measuring and understanding risk will our banking institutions remain vibrant, healthy, and competitive in meeting the growing financial demands of the nation while keeping systemic risk at acceptable levels. Therefore, the regulatory authorities must provide the industry with proper incentives to invest in risk-management systems that are necessary to compete successfully in an increasingly competitive and efficient global market. When I last discussed the condition of the banking industry with this committee in June 2001, the industry's asset quality had begun to decline, but from a relatively high level, and banks were generally well positioned to deal with the emerging problems. Moreover, as early as the late 1990s, both the industry and bank supervisors had begun to address the slippage in credit standards that was one of the causes of the drop in asset quality. By most measures, this was an unusually early stage in the economic cycle to begin addressing such deterioration. Today, with the benefit of hindsight, we can see that the weaknesses I cited then have indeed been mild for the banking system as a whole and that the system remains strong and well positioned to meet customer needs for credit and other financial services. During the past two years, in particular, the industry extended its string of high and often record quarterly earnings. For the full year 2003, commercial banks reported net profits of more than $100 billion while maintaining historically high equity and risk-based capital ratios and enjoying brisk asset growth. Although the demand for business loans and the underwriting of equity securities have been weak over the past few years, banking organizations have continued to benefit from strong demand for household credit, not least for residential mortgage products as interest rates declined substantially. Moreover, the volume of problem assets in commercial banks declined each quarter last year, including a drop in the fourth quarter of nearly 10 percent, which brought the ratio of problem assets to total loans and foreclosed assets to less than 1 percent- its lowest level since year-end 2000. As a result of this favorable performance, both the size and the number of bank failures in recent years have been exceptionally small. Last year, for example, only two banks, with combined assets of just $1.5 billion, failed. The results of last year's interagency review of large syndicated loans and internal reports about the level and distribution of their criticized and classified credits lead us to expect still further improvement in the industry's asset quality this year. Notably, the pool of "special mention" credits that are weak but still performing (and which tend to produce the more serious problem assets) has shrunk both in the annual Shared National Credit review and in the quarterly bank reports. Risk measures derived from prices of publicly traded bank securities -- stocks, debt securities, and credit default swaps -- also signal that market participants are taking an increasingly positive view of the future of banks. Indeed, these measures suggest the lowest level of market concern about these companies that we have seen during the five-years in which we have tracked them. The banking industry's relatively benign experience with loan losses these past few years may not be surprising given that the recession was mild by most measures. The experience is more notable, however, when one considers the broader range of shocks and developments that have occurred during this period, including the September 11 attacks, Argentina's credit default, the continuing shift by large and not-so-large firms in this country from bank to capital market financing, and the concentration of recent economic pressures on specific industries and business sectors. These events tended to reduce the overall quality of corporate loan portfolios at banks and contributed significantly to banks' efforts to improve their measurement and management of risks, especially after the substantial credit losses they suffered in the late 1980s and early 1990s. These efforts, aided by the continued trend toward industry consolidation, helped moderate previous concentrations of credit exposures in bank portfolios and fueled greater use of new methods of hedging and managing risk. At present, credit risk-management practices are perhaps least developed in measuring risk associated with exposures related to construction projects and to the financing of commercial real estate, which have grown rapidly, particularly among regional and community banks. At all banks, such lending represented nearly 19 percent of all bank loans at year-end 2003 -- the highest level thus far recorded -- and accounted for essentially all the loan growth last year at banks with less than $1 billion in assets. Despite the limited development of formal risk-management practices, credit standards applied to these loans have apparently been quite high. At least, we see as yet no signs of rising credit losses from such lending, and supervisory and market sources indicate that the poor lending practices of the late 1980s and early 1990s have been largely avoided. Nonetheless, the historical record provides ample evidence of the risks associated with this form of lending and of accumulating large credit concentrations in any form of exposure. Supervisors continue to monitor these concentrations and the lending practices and market conditions that will ultimately determine their effects on the banking system. These and other gradual changes in the balance sheets of banks, along with the sustained decline in market rates, helped compress net interest margins at many banks, as they chose not to reflect the full effect of lower market rates into rates paid on deposits without a specified maturity. As a percentage of earning assets, net interest income of all insured commercial banks declined 27 basis points last year, to 3.80 percent, the lowest level in more than a decade. Although this compression eased slightly during the fourth quarter, we cannot yet tell whether margins have begun to rebound. This compression of margins needs to be understood in the fuller context of the banks' sensitivity to changes in interest rates and, in particular, the effect of historically low rates on banks' financial performance and condition. At the same time that declining rates were adversely affecting the industry's interest margins, they were also spurring growth in mortgage-related assets and associated loan-origination fees and were producing significant capital gains in bank investment portfolios. Lower interest rates, along with the decline in equity valuations experienced during 2000-2002, also contributed to a substantial inflow of liquid deposits by lessening their opportunity cost. Under these circumstances, and with a steep yield curve, a banker's natural inclination might be to shift the credit mix and extend the maturity of assets in an attempt to bolster asset yields. To some extent such actions have been taken. Residential mortgage loans and pass-through securities have increased from 17.5 percent of assets in 2000 to 20 percent in 2003. But the manner in which this growth has occurred suggests a balanced assessment of risk. Call Report data indicate that a substantial portion of the increase in mortgage assets has been in adjustable-rate or shorter-term mortgages, particularly at smaller banks. For their part, large institutions also have significant capacity to offset on balance-sheet exposures through off-balance-sheet transactions. All told, the available data, industry and supervisory judgments, and the long and successful experience of the U.S. commercial banking system in dealing with changing rates suggest that, in general, the industry is adequately managing its interest rate exposure. Many banks indicate that they now either are interest-rate neutral or are positioned to benefit from rising rates. These views are based partly on specific steps that they have taken to adjust portfolios and partly on judgments about the effects that rising interest rates would have in easing pressure on interest margins. That is, many banks seem to believe that as rates rise -- presumably along with greater economic growth -- they can increase lending rates more than they will need to increase rates paid on deposits. Certainly, there are always outliers, and some banks would undoubtedly be hurt by rising rates. However, the industry appears to have been sufficiently mindful of interest rate cycles and not to have exposed itself to undue risk. In other areas, earlier concerns about the effect of the century date change on computer systems, the destruction of infrastructure in the September 11 attacks, and the increased volume and scope of banking transactions generally have also required financial institutions, particularly large institutions, to devote more effort and resources to contingency planning in order to ensure the continuity of their operations. Last fall's power outage and Hurricane Isabel may have offered only limited tests of the industry's improved procedures, but financial firms handled those challenges extremely well. As the nation's central bank and as a bank supervisor, the Federal Reserve has a strong interest in the continued operation of the U.S. financial system after a disruptive event. To that point, last year, the Federal Reserve Board, the Securities and Exchange Commission, and the Office of the Comptroller of the Currency jointly issued an interagency paper, "Sound Practices to Strengthen the Resilience of the U.S. Financial System." That paper provides guidance that supplements long-standing principles of business continuity planning and disaster recovery and is directed at the entities that pose systemic risk to the financial system, particularly in the context of their clearing and settlement activities. Through the Federal Financial Institutions Examination Council, we also issued revised examination guidance on business continuity planning. This guidance covers a variety of threats to business operations, including terrorism, and will be used in future examinations. Improved Risk Management in BanksIndependent of continuity planning for unusual events, the basic thrust of recent efforts to improve the management of risk has been better quantification and the creation of a formal and more disciplined process for recognizing, pricing, and managing risk of all types. In the area of credit risk, by providing those involved with a stronger, more-informed basis for making judgments, this development has enhanced the interaction between lending and risk-control officers. Operating with better information does not mean that banks will necessarily reduce credit availability for riskier borrowers. It does mean that banks can more knowingly choose their risk profiles and price risk accordingly. Better, more informed lending practices should also lead to a more-efficient allocation of scarce financial capital to the benefit of the economy at large. Greater internal transparency and quantification of risk have helped bank managers monitor portfolio performance and identify aspects of the risk-measurement and credit-granting process that begin to move off track. As risk-measurement and disclosure practices evolve, investors and uninsured creditors will also become more motivated and better positioned to understand the risk profile of banks and convey their own views of banking risks. Indeed, accommodating greater and more-informed market discipline is an important goal of bank supervisors. Perhaps most important, better risk management has already begun to show real potential for reducing the wide swings in bank credit availability that historically have been associated with the economic cycle. Sound procedures for risk quantification generally lead to tighter controls and assigned responsibilities and to less unintended acceptance of risk during both the strengthening and weakening phases of the business cycle. Earlier detection of deviations from expectations leads to earlier corrective actions by bank managers and, as necessary, by bank supervisors.Better methods for measuring credit risk have also spurred growth in secondary markets for weak or problem assets, which have provided banks with a firmer, sounder basis for valuing these credits and an outlet for selling them and limiting future loss. Insurance companies, hedge funds, and other investors acquire these assets at discounts that they judge are sufficient to meet their expected returns and balance their portfolio risks. The result is greater liquidity for this segment of bank loan portfolios and the earlier removal of weakening credits from bank balance sheets. Portfolio risks have also been increasingly hedged by transactions that do not require asset sales, such as derivatives that transfer credit risk. With greater use, more-thorough review, and more-extensive historical data, risk modeling has improved in accuracy and will continue to do so. Supervisors are also learning these techniques and are pressing banks to improve their own methods and systems to keep up with the latest developments. In the United States, our leading banking organizations began the process years ago and, in many respects, were in the vanguard of the effort worldwide. Nevertheless, they and the risk-measurement process itself have much further to go. Recent initiatives of the Basel Committee on Banking Supervision to revise international capital standards have helped focus attention on risk-measurement practices and have encouraged further investment in this area. Moreover, the very improvements in technology that facilitated better bank risk measurement and management have undermined the current regulatory capital regime by creating transactions and instruments "