The Newest class of derivatives are in some cases extremely complex and have not been tested in a downturn.

In light of this, it is interesting that one of the country’s top banking regulators—not Greenspan, but Timothy Geithner, president of the New York Federal Reserve—was able to ring alarm bells as loudly as he did in a mid-April speech to a financial industry trade group without precipitating a complete meltdown—indeed without any noticeable market reaction whatsoever.

Geithner, who also sits on the Fed’s Open Market Committee (the group that sets the nation’s monetary policy) essentially said that bank mergers had left the bulk of the industry in the hands of a few titans, and that “an event large enough to threaten the solvency or liquidity of one of these core institutions could have more severe impact on the stability of the system than was the case in a less concentrated market.”

“A severe impact on the stability of the system” is not a phrase one normally expects to hear from New York Fed presidents, who are considered moderately Sphinx-like themselves.

The banking sector was less concentrated, and therefore perhaps more flexible, when the Latin American debt crisis of the 1980s savaged the results of such firms (known then) as Citibank and Chase Manhattan; when the Tequila Crisis did the same to a broad array of banks a decade later; when Salomon Brothers flirted with insolvency after its bond trading scandal; when the New York Fed stepped in to avert the collapse of Long-Term Capital Management the list goes on. Government intervention in many of these episodes bolstered the common assumption among bankers and analysts that the government regarded the largest financial institutions too big to fail. This belief often led to further unwise risk taking and further losses down the road.

While more numerous, banks were less complicated back then. As Geithner pointed out, these institutions now use sophisticated risk management tools that have allowed them to weather more recent shocks—the Argentine debt default, 9/11, the Enron/WorldCom/Parmalat fiascos—without much pain. While these advances, along with external phenomena like low credit losses and less uncertainty about inflation and interest rates, are obviously welcome, he warned banks not to be complacent. In a phrase that one cannot imagine passing the august lips of Greenspan, Geithner said, “There is a self-reinforcing character to this pattern, with past stability seemingly increasing confidence in future stability, and this dynamic itself can magnify the risk of a more damaging reversal.”

The untested nature of many of the sector’s financial innovations and products is at issue, Geithner argues. But he is no demagogue. Unlike, say, Warren Buffett’s self-serving 2003 tirade about derivatives being “financial weapons of mass destruction” (from a man who just lost his shareholders tens of millions of dollars by speculating incorrectly in the currency derivatives markets), the Fed chief knows these instruments are the tools that have kept the financial system flexible enough to weather recent crises. However, he raised concerns that the newest class of derivatives, those based on credit, are in some cases extremely complex and have not been tested in a downturn. “The risk-reducing benefits of these innovations, for individual institutions and for the system as a whole, are substantial, but these benefits are to some extent qualified by the limits of our knowledge of how they will perform in conditions of stress,” he said.

Our financial system is so tightly integrated it often resembles one large organism. One bank’s largest customers are likely to be its competitors down the street. Ripples from a disaster at one firm will affect them all. Geithner and other regulators are urging banks to take steps to ensure they can survive such a financial contagion, unlikely though it may be. For individual investors of substantial means, it would be wise to heed the same advice.