Federal Reserve Chairman Alan Greenspan on Wednesday said there were signs that loan quality at U.S. banks was eroding amid a softening economy but warned lenders against tightening lending standards too far. 

``Many of the traditional quantitative and qualitative indicators suggest that bank asset quality is deteriorating and that supervisors therefore need to be more sensitive to problems at individual banks, both currently and in the months ahead,'' Greenspan told the Senate Banking Committee. 

He said weaker economic conditions had ``especially affected borrowers in the retail, manufacturing, health care and telecommunications industries,'' adding that California utility companies were under particular pressure. 

But the U.S. central bank chief said the U.S. banking system had ``entered this period of weak economic performance in a strong position'' and cautioned against overreacting to a growing number of loans whose repayment may be in question. 

Greenspan noted that when loans on banks' books begin to go bad, there can be a tendency to substantially tighten lending standards for new loans in a way that could choke off credit. 

``Such policies are demonstrably not in the best interests of banks' shareholders or the economy,'' he said. ``They lead to an unnecessary degree of cyclical volatility in earnings...More importantly, such policies contribute to increased economic instability.'' 

In a report accompanying Greenspan's testimony, however, the Fed said banks seemed to be striking a fair balance. 

``At present the tightening of terms and standards at banks...has not inhibited the flow of funding to sound borrowers,'' the report said. ``So far banks seem to be making balanced decisions on the trade-off between risk and returns.'' 

Greenspan's message was echoed by other top U.S. bank regulators at the committee hearing. 

``We believe the condition of the banking industry is strong,'' Comptroller of the Currency John Hawke said. ``We are however in a period of heightened uncertainty concerning the domestic and global economic outlook.'' 

``If the U.S. slowdown becomes deeper and persists, the effects on the banking industry will be much more serious...Declining earnings would heighten concerns about the safety and soundness of certain banks,'' he added. 

Greenspan said big banks especially had made significant progress at developing systems for recognizing, pricing and managing loan risks. He said this was now reflected in the lending process and should help banks make better loans that will be less volatile when economic conditions change. 

``This is a sea change -- or at least the beginning of one,'' he said. ``Formal risk management systems are designed to reduce the potential for the unintended acceptance of risk and hence should reduce the pro-cyclical behavior that has characterized banking history.''