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https://www.federalreserve.gov/boarddocs/speeches/1996/19961219.htm

Supervision of bank risk-taking

Vice Chair Alice M. Rivlin

At the The Brookings Institution National Issues Forum, Washington, D.C.

I discovered when I joined the Board of Governors of the Federal Reserve System about six months ago that most of my friends including my sophisticated public policy oriented friends had only a hazy notion what their central bank did. Many of them said, enthusiastically, "Congratulations!" Then they asked with a bit of embarrassment, "Is it a full-time job?" or "What will you find to do between meetings?" The meetings they were aware of, of course, were those of the Federal Open Market Committee. They knew that the FOMC meets every six weeks or so to "set interest rates." That sounds like real power, so the FOMC gets a lot of press attention even when, as happened again this week, we meet and decide to do absolutely nothing at all. The group gathered here today, however, realizes that monetary policy, while important, is not actually very time-consuming. If you cared enough to come to this conference, you also have a strong conviction that the health and vigor of the American economy depends not only on good macro-economic policy, although that certainly helps, but also on the safety, soundness and efficiency of the banking system. We need a banking system that works well and one in which citizens and businesses, foreign and domestic, have high and well placed confidence. So I want to talk today, as seems appropriate on the fifth anniversary of FDICIA, about the subject that occupies much of our attention at the Federal Reserve: the prudential regulation of banks and how to improve it. Indeed, I want to focus today, not so much on what Congress needs to do to ensure the safety and soundness of the bank system in this rapidly changing world there are others on the program to take on that task but more narrowly on how bank regulators should go about their jobs of supervising bank risk-taking. The evolving search for policies that would guarantee a safe, sound and efficient banking system has featured learning from experience. In the 1930s, Americans learned, expensively, about the hazards of not having a safety net in a crisis that almost wiped out the banking system. In the 1980s, they learned a lot about the hazards of having a safety net, especially about the moral hazard associated with deposit insurance. Deposit insurance, which had seemed so benign and so successful in building confidence and preventing runs on banks, suddenly revealed its downside for all to see. Some insured institutions, mostly thrifts, but also savings banks, and not a few commercial banks, were taking on risks with a "heads I win, tails you lose" attitude sometimes collecting on high stakes bets but often leaving deposit insurance funds to pick up the pieces. At the same time, some regulators, especially the old FSLIC, which was notably strapped for funds, were compounding the problem and greatly increasing the ultimate cost of its resolution by engaging in regulatory "forbearance" when faced with technically insolvent institutions. Return to top The lessons were costly, but Americans do learn from their mistakes. The advocates of banking reform, many of them participants in this conference, saw the problems posed by moral hazard in the context of ineffectual supervision and set out to design a better system. Essentially, the reform agenda had two main components: First, expanded powers for depository institutions that would permit them to diversify in ways that might reduce risks and improve operating efficiency; Second, improving the effectiveness of regulation and supervision by instructing regulators, in effect, to act more like the market itself when conducting prudential regulation. FDICIA was a first step toward meeting the second challenge how to make regulators act more like the market. It called for a reduction in the potential for regulatory "forbearance" by laying down the conditions under which conservatorship and receivership should be initiated. It called for supervisory sanctions based on measurable performance (in particular, the Prompt Corrective Action provisions that based supervisory action on a bank's risk-based capital ratio). The Act required the FDIC and RTC to resolve failed institutions on a least-cost basis. In other words, the Act required the depository receivers to act as if the insurance funds were private insurers, rather than continue the past policy of protecting uninsured depositors and other bank creditors. Finally, FDICIA placed limitations on the doctrine of "Too Big To Fail," by requiring agency consensus and administration concurrence in order to prop up any large, failing bank. In a few places, however, FDICIA went too far. The provisions of the Act that dealt with micro management by regulators were immediately seen to be "over the top," and were later repealed. The Act provided a framework for regulators to invoke market-like discipline. It left room for them to move their own regulatory techniques in this direction a subject to which I will return in a minute. The other objective of reform diversification of bank activities through an expansion of bank powers has not yet resulted in legislation and is still very much an on-going debate. In part, this failure to take legislative action reflected the long-running ability of the nonbank competition to use its political muscle to forestall increased powers for banks. But the inaction on expanded powers also reflected a Congressional concern that additional powers might be used to take on additional risk, which, on the heels of the banking collapse of the late 1980s, represented poor timing, to say the least. There was also some Congressional disposition to punish "greedy bankers," who were seen as the reason for the collapse and the diversion of taxpayer funds to pay for thrift insolvencies. Whatever the reasons, not only did the 102nd Congress fail to enact expanded bank powers, but so did the next two Congresses. We are hopeful that the 105th Congress will succeed where its predecessors have failed. Meanwhile, the regulatory agencies have acted to expand bank powers within the limits of existing law. The Federal Reserve has proposed both liberalization of Section 20 activities and expedited procedures for processing applications under Regulation Y. The OCC has acted to liberalize banks' insurance agency powers and, most recently, to liberalize procedures for operating subsidiaries of national banks. Of course, I would have to turn in my Federal Reserve badge and give up my parking pass if I did not mention that we at the Fed believe that some activities are best carried out in a subsidiary of the holding company rather than a subsidiary of the bank. We believe that the more distance between the bank and its new, nonbank operations, the more likely that we can separate one from the other and avoid the spreading of the subsidy associated with the safety net. Return to top While the regulators can move in the right direction, it is still imperative that Congress act. Artificial barriers between and among various forms of financial activity are harmful to the best interests of the consumers of financial services, to the providers of those services, and to the general stability and well-being of our financial system, most broadly defined. Congress should consider this issue and take the next steps. Let me turn now to what I consider to be one of the most critical issues facing regulators, especially in a future in which financial markets likely will dictate significant further increases in the scope and complexity of banking activities. I am referring to the issue of how to conduct optimal supervision of banks. Fortunately, there appears actually to be an evolving consensus at least on the general principle. Regulators, including the Federal Reserve, strongly support the basic approach embodied in FDICIA; namely that regulators should place limits on depository institutions in such a way as to replicate, as closely as possible, the discipline that would be imposed by a marketplace consisting of informed participants and devoid of the moral hazard associated with the safety net. Unfortunately, as always, the devil is in the details. The difficult question is how should a regulator use "market-based" or "performance-based" measures in determining which, if any, supervisory sanctions or limits to place on a bank. FDICIA's approach was straightforward. Supervisory sanctions under Prompt Corrective Action were to be based on the bank's risk performance as measured by its levels of regulatory capital, in particular its leverage ratio and total risk-based capital ratio under the Basle capital standards. These standards now seem well-intended but rather outdated. Certainly, the Basle capital standards did the job for which they were designed, namely stopping the secular decline in bank capital levels that, by the late 1980s, threatened general safety and soundness. But the scope and complexity of banking activities has proceeded apace during the last two decades or so, and standard capital measures, at least for our very largest and most complex organizations, are no longer adequate measures on which to base supervisory action for several reasons: The regulatory capital standards apportion capital only for credit risk and, most recently, for market risk of trading activities. Interest rate risk is dealt with subjectively, and other forms of risk, including operating risk, are not treated within the standards. Also, the capital standards are, despite the appellation "risk-based," very much a "one-size-fits-all" rule. For example, all non-mortgage loans to corporations and households receive the same arbitrary 8 percent capital requirement. A secured loan to a triple-A rated company receives the same treatment as an unsecured loan to a junk-rated company. In other words, the capital standards don't measure credit risk although they represent a crude proxy for such risk within broad categories of banking assets. Finally, the capital standards give insufficient consideration to hedging or mitigating risk through the use of credit derivatives or effective portfolio diversification. Return to top These shortcomings of the regulatory capital standards were beginning to be understood even as they were being implemented, but no consistent, consensus technology existed at that time for invoking a more sophisticated standard than the Basle norms. To be sure, more sophisticated standards were being used by bank supervisors, during the examination process, to determine the adequacy of capital at any individual institution. These supervisory determinations of capital adequacy on a bank-by-bank basis, reflected in the CAMEL ratings given to banks and the BOPEC ratings given to bank holding companies, are much more inclusive than the Basle standards. Research shows that CAMEL ratings are much better predictors of bank insolvency than "risk-based" capital ratios. But, a bank-by-bank supervision, of course, is not the same thing as the writing of regulations that apply to all banks. It is now evident that the simple regulatory capital standards that apply to all banks can be quite misleading. Nominally high regulatory capital ratios even risk-based capital ratios that are 50 or 100 percent higher than the minimums are no longer indicators of bank soundness. Meanwhile, however, some of our largest and most sophisticated banks have been getting ahead of the regulators and doing the two things one must do in order to properly manage risk and determine capital adequacy. First, they are statistically quantifying risk by estimating the shape of loss probability distributions associated with their risk positions. These quantitative measures of risk are calculated by asset type, by product line, and, in some cases, even down to the individual customer level. Second, the more sophisticated banks are calculating economic capital, or "risk capital," to be allocated to each asset, each line of business, and even to each customer, in order to determine risk-adjusted profitability of each type of bank activity. In making these risk capital allocations, banks are defining and meeting internal corporate standards for safety and soundness. For example, a banker might desire to achieve at least a single-A rating on his own corporate debt. He sees that, over history, single-A debt has a default probability of less than one-tenth of one percent over a one year time horizon. So the banker sets an internal corporate goal to allocate enough capital so that the probability of losses exceeding capital is less than 0.1 percent. In the language of statistics, this means that allocated capital must "cover" 99.9 percent of the estimated loss probability distribution. Once the banker estimates risk and allocates capital to that risk, the internal capital allocations can be used in a variety of ways for example, in so-called RAROC or risk-adjusted return on capital models that measure the relative profitability of bank activities. If a particular bank product generates a return to allocated capital that is too low, the bank can seek to cut expenses, reprice the product, or focus its efforts on other, more profitable ventures. These profitability analyses, moreover, are conducted on an "apples-to-apples" basis, since the profitability of each business line is adjusted to reflect the riskiness of the business line. What these bankers have actually done themselves, in calculating these internal capital requirements, is something regulators have never done defined a bank soundness target. What regulator, for example, has said that he wants capital to be high enough to reduce to 0.1 percent the probability of insolvency? Regulators have said only that capital ratios should be no lower than some number (8 percent in the case of the Basle standards). But as we should all be aware, a high capital ratio, if it is accompanied by a highly risky portfolio composition, can result in a bank with a high probability of insolvency. The question should not be how high is the bank's capital ratio, but how low is its failure probability. Return to top In sharp contrast to our 8 percent one-size-fits-all capital standard, the internal risk-capital calculations of banks result in a very wide range of capital allocations, even within a particular category of credit instrument. For example, for an unsecured commercial credit line, typical internal capital allocations might range from less than 1 percent for a triple-A or double-A rated obligor, to well over 20 percent for an obligor in one of the lowest rating categories. The range of internal capital allocations widens even more when we look at capital calculations for complex risk positions such as various forms of credit derivatives. This great diversity in economic capital allocations as compared to regulatory capital allocations, creates at least two types of problem. When the regulatory capital requirement is higher than the economic capital allocation, the bank must either engage in costly regulatory arbitrage to evade the regulatory requirement or change its portfolio, possibly leading to suboptimal resource allocation. When the regulatory requirement is lower than the economic capital requirement, the bank may choose to hold capital above the regulatory requirement but below the economic requirement; in this case, the bank's nominally high capital ratio may mask the true nature of its risk position. Measuring bank soundness and overall bank performance is becoming more critical as the risk activities of banks become more complex. This condition is especially evident in the various nontraditional activities of banks. In fact, "nontraditional" is no longer a very good adjective to describe much of what goes on at our larger institutions. Take asset securitization, for example. No longer do our largest banks simply take in deposit funds and lend out the money to borrowers. Currently, well over $200 billion in assets that, in times past, have resided on the books of banks, now are owned by remote securitization conduits sponsored by banks. Sponsorship of securitization, which is now almost solely a large bank phenomenon, holds the potential for completely transforming the traditional paradigm of "banking." Now, loans are made directly by the conduits, or are made by the banks and then immediately sold to the conduits. To finance the origination or purchase of the loans, a conduit issues several classes of asset-backed securities collateralized by the loans. Most of the conduit's debt is issued to investors who require that the senior securities be highly rated, generally double-A and triple-A. In order to achieve these ratings, the conduit obtains credit enhancements insulating the senior security holders from defaults on the underlying loans. Generally, it is the bank sponsor that provides these credit enhancements, which can be in the form of standby letters of credit to the conduit, or via the purchase of the most junior/subordinated securities issued by the conduit. In return for providing the credit protection, as well as the loan origination and servicing functions, the bank lays claim to all residual spreads between the yields on the loans and the interest and non-interest cost of the conduit's securities, net of any loan losses. In other words, securitization results in banks taking on almost identically the same risks as if the loans were kept on the books of the bank the old-fashioned way. Return to top But while the credit risk of a securitized loan pool may be the same as the credit risk of holding that loan pool on the books, our capital standards do not always recognize this fact. For example, by supplying a standby letter of credit covering so-called "first-dollar" losses for the conduit, a bank might be able to reduce its regulatory capital requirement, for some of its activities, by 90 percent or more compared with what would be required if the bank held the loans directly on its own books. The question, of course, is whether the bank's internal capital allocation systems recognize the similarity in risk between, on the one hand, owning the whole loans and, on the other hand, providing a credit enhancement to a securitization conduit. If the risk measurement and management systems of the bank are faulty, then holding a nominally high capital ratio say, 10 percent is little consolation. In fact, nominally high capital ratios can be deceiving to market participants. If, for example, the bank's balance sheet is less than transparent, potential investors or creditors, seeing the nominally high 10 percent capital, but not recognizing that the economic risk capital allocation should, in percentage terms, be much higher, could direct an inappropriately high level of scarce resources toward the bank. Credit derivatives are another example of the evolution. The bottom line is that, as we move into the 21st century, traditional notions of "capital adequacy" will become less useful in determining the safety and soundness of our largest, most sophisticated, banking organizations. This growing discrepancy is important because "performance-based" solutions likely will continue to be touted as the basis for expanded bank powers or reductions in burdensome regulation. For example, the Federal Reserve's recent proposed liberalization of procedures for Regulation Y activities applies to banking companies that are "well-capitalized" and "well-managed." Similarly, the OCC's recent proposed liberalization of rules for bank operating subsidiaries applies to "well-capitalized" institutions. Also, industry participants continue to call for expanded powers and/or reduced regulatory burden based on "market tests" of good management and adequate capital. It will not be easy reaching consensus on how to measure bank soundness and overall bank performance. It cannot simply be done by observing market indicators. For example, we cannot easily use the public ratings of holding company debt. The ratings, after all, are achieved given the existence of the safety net. The ratings are biased, therefore, from the perspective of achieving our stated goal to impose prudential limits on banks as if there were no net. In addition, I am sure that there would be disagreement between market participants and regulators over what should be acceptable debt ratings. The solution may be for the regulators to use the analytical tools developed by the market participants themselves for risk and performance assessment. Regulators already have begun to move in this direction. For example, beginning in January 1998, qualifying large multinational banks will be able to use their internal Value-at-Risk models to help set capital requirements for the market risk inherent in their trading activities. The Federal Reserve is also conducting a pilot test of the pre-commitment approach to capital for market risk. In this approach, banks can choose their own capital allocations, but would be sanctioned heavily if cumulative trading losses during a quarter were to exceed their chosen capital allocations. These new and innovative methods for treating the age-old problem of capital adequacy are likely to be followed by an unending, evolutionary flow of improvements in the prudential supervisory process. As the industry makes technological advances in risk measurement, these advances will become imbedded in the supervisory process. For example, the banking agencies have announced programs to place an increased emphasis on banks' internal risk measurement and management processes within the assessment of overall management quality that is, how well a bank employs modern technology to manage risk will be reflected in the "M" portion of the bank's CAMEL rating. In a similar vein, now that VaR models are being used to assess regulatory capital for market risk, it is easy to envision that, down the road, banks' internal credit risk models and associated internal capital allocations will also be used to help set regulatory capital requirements. Regulation and supervision, like industry practices themselves, are continually evolving processes. As supervisors, our goal must be to stay abreast of best practices, incorporate these practices into our own procedures where appropriate, and do so in a way that allows banks to remain sufficiently flexible and competitive. In conducting prudential regulation we should always remember that the optimal number of bank failures is not zero. Indeed, "market-based" performance means that some institutions, either through poor management choices, or just because of plain old bad luck, will fail. As regulators, we must carefully balance these market-like results with concerns over systemic risk. And, as regulators of banks, we must always remember that we do not operate in a vacuum the activities of nonbank financial institutions are also important to the general well-being of our financial system and the macro economy. Regulators, of course, can only work with the framework laid down by Congress. Let me conclude with the hope that this Congress will build on the experience of the last few years, including the experience with FDICIA, and take the next steps toward creating a structural and regulatory framework appropriate to the 21st century.

D.C.

https://www.federalreserve.gov/boarddocs/speeches/1996/19961206.htm

Social security

Chairman Alan Greenspan

At the Abraham Lincoln Award Ceremony of the Union League of Philadelphia, Philadelphia, Pennsylvania

I am privileged to accept the Union League of Philadelphia's Abraham Lincoln award. This is the first time I have been at the Union League in nearly four decades, but I am gratified to learn that your organization remains as vital and active as it was in the 1950s when I visited friends here with some frequency. Today I would like to address an issue that almost certainly will be at the forefront of American concerns over the next decade: our largest federal entitlement program, social security. It is becoming conventional wisdom that the social security system, as currently constructed, will not be fully viable after the so-called baby boom generation starts to retire in about fifteen years. The most recent report by the social security trustees projected that the trust funds of the system will grow over approximately the next fifteen years. However, beginning in the year 2012, the annual expected costs of social security are projected to exceed annual earmarked tax receipts, and the consequent deficits are projected to deplete the trust funds by the year 2029. While such evaluations are based on an uncertain future, the benefit per current retiree under existing law, adjusted for inflation, can be forecast with some precision over the next thirty years. Somewhat less precision is possible for future retirees. The price escalation of benefits, of course, is even more difficult to pin down. But since price inflation has an equal effect on wages subject to social security taxation, for all practical purposes, the degree of inflation does not have a large direct effect on the net funding of the system over the long run. However, the rate of inflation, because it affects the overall economy, presumably does affect the real wage base from which social security taxes and future benefits are derived. The projection of inflation-adjusted taxes, which are subject to a wider degree of uncertainty than total benefits, is largely driven by real wage growth that is, wage growth adjusted for inflation which, in turn, is primarily determined by the growth of productivity. Projecting productivity in line with the pattern of the last quarter century suggests a trend of revenue falling far short of the levels required to finance the benefits of the large baby-boomer bulge in retirees anticipated to start at about 2010. I should state, parenthetically, that if recent productivity trends are underestimated, as I suspect they are, for much the same reasons are the projected trends of both real benefits and payroll taxes. The real future funding shortfall, therefore, would not be materially affected. Our social security problem is, thus, not merely statistical; it is the consequence of a projected shortfall in real resources dedicated to social security. In money terms, the current social security trust fund of a half trillion dollars falls far short of the levels required to fund the current obligations to pay promised benefits to those already retired and those who will retire in the years ahead. Social security, unlike fully funded private retirement programs, is largely an intergenerational transfer. Today's workers are essentially paying for today's retirees. Under the current system, the social security benefits paid to today's workers when they retire in the future will be primarily dependent upon the payroll taxes acquired from future workers. Accordingly, if the social security system is to survive in its current form, either real benefits must be curtailed, or real taxes increased. The latter can come from either higher tax rates or higher real wage growth in effect, higher productivity growth. However, as I will be explaining shortly, higher productivity is unlikely alone to do the trick. Moreover, increased social security tax rates, of course, are controversial in that many perceive them, myself included, to adversely affect employment. A primary cause of social security's funding imbalance stems from the fact that, until very recently, the payments into the social security trust accounts by the average employee, plus employer contributions and interest earned, were inadequate, at retirement, to fund the total of retirement benefits. This has started to change. Under the most recent revisions to the law, and presumably conservative economic and demographic assumptions, today's younger workers will be paying social security taxes over their working years that appear sufficient to fund their benefits during retirement. However, the huge unfunded liability for current retirees, as well as for much of the work force closer to retirement, leaves the system, as a whole, badly underfunded. As longevity improved far beyond that contemplated by the creators of the system, and productivity growth slowed after 1973, the original premise of the system of intergenerational balance began to fail. Today the official unfunded liability for the Old Age, Survivors, and Disability funds, which takes into account expected future tax payments and benefits out to the year 2070, has reached a staggering $3 trillion. Return to top The social security trustees currently project taxes and benefits, under existing, and of necessity, quite tentative economic assumptions, that imply that fully funding social security for the next seventy-five years would require an immediate and permanent increase in social security taxes of about 2.2 percentage points of taxable payrolls on top of the current 12.4 percent tax rate, assuming that such an increase would not impede economic growth. Of course, benefit reductions of a similar magnitude, or a mix of tax hikes and benefit cuts, could also bring the system back into long-term actuarial balance, at least statistically. These types of program adjustments, which on the surface seem quite modest, might nonetheless be perceived as transforming what has until recently been a largely popular, subsidized, intergenerational transfer system into something quite contentious. Moreover, the longer action is deferred, the greater will be the necessary tax increases or, more likely, benefit adjustments required to achieve the goal of long-term actuarial balance. Clearly, something has to give. The question is what? We cannot hope to grow our way out of the problem. An immediate and sustained increase in annual productivity growth of about 2 percentage points apparently would be needed to close the long-run funding gap without an increase in taxes or a cut in benefits. The improvement in productivity growth must be this large because higher productivity raises future benefits as well as current and future tax receipts. However, given that we struggle to devise economic policies that might raise productivity growth by a few tenths of a percentage point per annum, a gain of 2 full points seems beyond the reach of credibility. Nonetheless, this issue does underscore the critical elements in the forthcoming debate, since it focuses on the core of any retirement system, private or public. Simply put, unless social security taxes increase, or as I just indicated, more likely, benefits are adjusted, domestic savings must increase. Potential beneficiaries must further abstain from consuming all of their incomes. Enough must be set aside over a lifetime of work to fund the excess of consumption over any non-social security income a retiree may still enjoy. At the simplest level, one could envision households saving by actually storing goods purchased during their working years for consumption during retirement. Even better, the resources that would have otherwise gone into the stored goods could be diverted to the production of new capital assets, which would, cumulatively, over a working lifetime, produce an even greater quantity of retirement goods and services. In short, we would be getting more output per worker, our traditional measure of productivity, and a factor that is central in all calculations of long-term social security trust fund financing. Hence, the bottom line in all retirement programs is physical resource availability. The finance of any system is merely to facilitate the underlying system of allocating real resources that fund retirement consumption of goods and services. The basic premise of our current largely pay-as-you-go social security system is that future productivity growth will be adequate to supply promised retirement benefits for current workers. At existing rates of saving and investment this is becoming increasingly dubious. Accordingly, there are a number of initiatives, at a minimum, that will surely have to be addressed. As I argued at length in the Social Security Commission deliberations of 1983, with only marginal effect, some delaying of the age of eligibility for retirement benefits will become increasingly pressing. For example, adjusting the full-benefits retirement age to keep pace with increases in life expectancy would keep the ratio of retirement years to expected lifespan approximately constant and would help to significantly narrow the funding gap. Hopefully, other modifications to social security benefits also will be judged as necessary. Moreover, it is becoming increasingly recognized that the Consumer Price Index overstates increases in the cost of living, and thus indexing social security benefits to the CPI goes far beyond the intent of the Congress to insulate retirees from inflation. In that regard, the recently released report from the Boskin commission makes a valuable contribution to the emerging consensus on this issue. But, unless future taxes and/or benefits are sufficiently adjusted, there is no substitute for increased domestic savings and investment currently. To be sure, for relatively short periods of time we can finance part of domestic investment in plant and equipment with foreign savings as we are doing today. History, however, tells us that there is a limit to how far that can go. We are also apparently increasing the productivity of our capital. It is possible that the maturing of emerging technologies, and further substantial deregulation of industry and finance, will, in themselves, improve the growth rate of productivity without large capital investment and savings. But, it would take implausible improvements in capital productivity from current rates to close very much of the social security funding gap from this source. The necessary boost in domestic savings need not be derived from an improved social security system, but certainly a reduction in the social security funding gap would itself move in that direction. In a sense, it could create a virtuous cycle with higher savings engendering higher productivity growth which, in turn, would narrow the funding gap still further. Of course, additional saving can be achieved through a reduction in the overall federal government budget deficit, and intensified efforts to encourage private household and business savings. Return to top Some have argued for a provision in law to require the social security trust funds to invest in higher-yielding private securities, especially equities, rather than in U.S. Treasuries only. A higher rate of return, it is alleged, would help solve the social security funding problem. That may in fact be the case, but if so, what would happen to private retirement programs? If social security trust funds are shifted in part, or in whole, from U.S. Treasury securities to private debt and equity instruments, holders of those securities in the private sector must be induced to exchange them, net, for U.S. Treasuries. If, for example, social security funds were invested wholly in equities, presumably they would have to be purchased from the major holders of such equities. Private pension and insurance funds, among other holders of equities, presumably would have to swap equities for Treasuries. But, if the social security trust funds achieved a higher rate of return investing in equities than in lower yielding U.S. Treasuries, private sector incomes generated by their asset portfolios, including retirement funds, would fall by the same amount, potentially jeopardizing their financial condition. This zero-sum result occurs because of the assumption that no new productive saving and investment has been induced by this portfolio reallocation process. Proceeding further, one must presume that in such a circumstance, in order to induce the private sector to exchange their equities for Treasuries, equity prices must rise and bond prices fall. But, this would create great market tension. Bonds and equities are merely the paper claims to income earning assets, and the value of the income stream is not determined by short-run changes in the supply and demand for securities. Rather, equity prices must, in the long run, reflect the underlying earnings of the corporations on which the equities are a claim, as well as society's need to be compensated for postponing consumption into the future and its perception and attitudes toward risk as a consequence of uncertainty about the future. Indeed, the total market value of debt plus equities, is, to a first approximation, likely to be unaffected by a shift in the balance of paper claims. One might expect that this tension between the altered relative supply of equity and debt claims, on the one hand, and unaltered overall economic value of the nation's companies, on the other hand, would be resolved by an increase in the issuance of equity securities relative to bonds. This could reverse much, if not all, of the price shift in favor of equities. However, to complicate the issue still further, it is not clear as to whether, and to what extent, bond prices would rise as corporations cut back on debt issuance. Certainly with the social security trust funds no longer investing all of their surplus in U.S. Treasuries, the federal debt held by the public would rise, presumably placing downward pressure on bond prices. At best, the results of this restricted form of privatization are ambiguous. Thus, the dilemma for the social security trust funds is that a shift to equity investments without an increase in domestic savings may not appreciably increase the rate of return of social security trust fund assets, and to whatever extent that it does, would likely be mirrored by a comparable decline in the incomes of private pension and retirement funds. I should stress that this does not mean that at least a partial privatization of our social security system does not provide a potentially viable solution to current funding problems. There are a number of thoughtful initiatives that, through the process of privatization, could increase domestic saving rates. These are clearly worthy of intensive evaluation. Perhaps the strongest argument for privatization is that replacing the current unfunded system, which apparently discourages saving, with a fully funded system, is that such a change could boost domestic saving. But, in any event, we must remember it is because privatization plans might increase savings that makes them potentially viable, not their particular form of financing. The types of changes that will be required to restore fiscal balance to our social security accounts, in the broader scheme of things, are significant but manageable. More important, most entail changes that are less unsettling if they are put into effect in the near term rather than waiting five or ten years or longer. Minimizing the potential disruptions associated with the inevitable changes to social security is made all the more essential because of the pressing financial problems in the Medicare system, social security's companion program for retirees. Medicare currently is in an even more precarious position than social security. The financing of Medicare faces some of the same problems associated with demographics and productivity as social security but faces different, and currently greater, pressures owing to the behavior of medical costs and utilization rates. Reform of the Medicare system will require more immediate and potentially more dramatic changes than those necessary to reform social security. We owe it to those who will retire after the turn of the century to be given sufficient advance notice to make what alterations in retirement planning may be required. The longer we wait to make what are surely inevitable adjustments, the more difficult they will become. If we procrastinate too long, the adjustments could be truly wrenching. Our citizens deserve better.

Pennsylvania

https://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm

The challenge of central banking in a democratic society

Chairman Alan Greenspan

At the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C.

The Challenge of Central Banking in a Democratic Society Good evening ladies and gentlemen. I am especially pleased to accept AEI's Francis Boyer Award for 1996 and be listed with so many of my friends and former associates. In my lecture this evening I want to give some personal perspectives on central banking and, consequently, I shall be speaking only for myself. William Jennings Bryan reportedly mesmerized the Democratic Convention of 1896 with his memorable ". . . you shall not crucify mankind upon a cross of gold." His utterances underscored the profoundly divisive role of money in his time a divisiveness that remains apparent today. Bryan was arguing for monetizing silver at an above-market price in order to expand the money supply. The presumed consequences would have been an increase in product prices and an accompanying shift in the value of net claims on future wealth from the "monied interests" of the East to the indebted farmers of the West who would arguably be able to pay off their obligations with cheaper money. The debates, before and since, over the issue of our money standard have mirrored the deliberations on the manner in which we have chosen to govern ourselves, and, perhaps more fundamentally, debates on the basic values that should govern our society. For, at root, money serving as a store of value and medium of exchange is the lubricant that enables a society to organize itself to achieve economic progress. The ability to store the fruits of one's labor for future consumption is necessary for the accumulation of capital, the spread of technological advances and, as a consequence, rising standards of living. Clearly in this context, the general price level, that is, the average exchange rate for money against all goods and services, and how it changes over time, plays a profoundly important role in any society, because it influences the nature and scope of our economic and social relationships over time. It is, thus, no wonder that we at the Federal Reserve, the nation's central bank, and ultimate guardian of the purchasing power of our money, are subject to unending scrutiny. Indeed, it would be folly were it otherwise. A central bank in a democratic society is a magnet for many of the tensions that such a society confronts. Any institution that can affect the purchasing power of the currency is perceived as potentially affecting the level and distribution of wealth among the participants of that society, hardly an inconsequential issue. Not surprisingly, the evolution of central banking in this nation has been driven by such concerns. The experiences with paper money during the Revolutionary War were decidedly inauspicious. "Not worth a Continental" was scarcely the epithet one would wish on a medium of exchange. This moved Alexander Hamilton, with some controversy, to press for legislation that established the soundness of the credit of the United States by assuming, and ultimately repaying, the war debts not only of the fledgling federal government, but of the states as well. Equally controversial was the chartering of the First Bank of the United States, which, although it had few functions of a modern central bank, was nonetheless believed to be a significant threat to states rights and the Constitution itself. Although majority controlled by private interests, the Bank engaged in actions perceived to shift power to the federal government. Such a shift was thought of by many as a fundamental threat to the new democracy, and an essential element of what was feared to be a Hamilton plan to re-establish a powerful aristocracy. The First Bank and especially its successor Second Bank of the United States endeavored to restrict state bank credit expansion when it appeared inordinate, by gathering bank notes and tendering them for specie. This reduced the reserve base and the ability of the fledgling American banking system to expand credit. The issue of states' rights and concern about the power of the central government reflected the free wheeling individualism of that time. The Second Bank was a major issue of the election of 1832. Earlier in that year, President Andrew Jackson had vetoed the bill to extend its charter, and the election became a referendum on his veto. The outcome was a resounding victory for Jackson and the death knell for the Bank. It has not been easy, however, to separate often seemingly conflicting threads in the debate between advocates of state powers over money and those seeking a national role. When Andrew Jackson vetoed the charter renewal of the Second Bank of the United States, for example, he argued for the severing of the grip on the economy of easterners and especially foreigners, who owned a significant stock interest in the bank. Ironically, by helping to create what was perceived to be an unstable currency, he set the stage for the later development of a full-fledged gold standard, the institution that Bryan railed against in 1896 from much the same populist philosophical base as Jackson. After the Civil War, redemption of the paper greenbacks issued during the war brought an era of a gold-standard-induced deflation, which, while it may not have thwarted the impressive advance of industrialization, was seen by many as suppressing credit availability for the rural interests of the nation, which were still a majority. The general price level declined for more than two decades, which meant borrowers were paying off their loans in more expensive dollars than those they borrowed. Not surprisingly, mounting pressures developed for reform, with Bryan bearing the standard for subsidized silver coinage, that is, free silver. Though Bryan lost to McKinley in 1896 (and again in 1900), the rural-based pressures for a more elastic currency did not diminish and ultimately were reflected, in part, in the creation of the Federal Reserve. Nonetheless, many of the proponents of banking reform in the 1890s, and in the aftermath of the Panic of 1907, were suspicious of creating a central bank. In very large measure, those concerns underlay the various threads of reform that were joined together in the design and creation of the Federal Reserve System in 1913. Its founding followed a prolonged debate on the balance of power between the interests of the New York money center banks and the rest of the nation, still largely rural. The compromise that resulted from that debate created twelve regional Reserve Banks with a Washington presence vested with a Federal Reserve Board. Its purpose was to "furnish an elastic currency, . . . to establish a more effective supervision of banking in the United States, and for other purposes." Monetary policy as we know it today, was not among the "other purposes." That evolved largely by accident in the 1920s. Return to top Even with a central bank, the gold standard was still the dominant constraint on the issuance of paper currency and the expansion of bank deposits. Accordingly, the Federal Reserve was to play a minor role in affecting the purchasing power of the currency for many years to come. The world changed markedly with the advent of the Great Depression of the 1930s, and the evisceration of the gold standard. The upheaval, and still festering fear of New York "monied interests," engendered the Banking Acts of 1933 and more importantly of 1935, which vested more of the Federal Reserve's authority with the Board of Governors in Washington. During World War II, and through 1951, however, monetary policy was effectively subservient to the interests of the Treasury, which sought access to low-cost credit. With the so-called Federal Reserve-Treasury Accord of 1951, the Federal Reserve began to develop its current degree of independence. Although in the 1950s and early 1960s there were short-lived bouts of inflation that caused momentary concern about sustained increases in the price level, these events did little to shake the conviction of most that America's economic and financial structure would indefinitely and effectively contain any inflationary forces. This prescription certainly seems to have been reflected in the low inflation premium then embedded in long-term bonds. That this view was profoundly wrong soon became apparent. The 1970s saw inflation and unemployment simultaneously at relatively elevated levels for some time. The notion that this could occur was nowhere to be found in the conventional wisdom of the economic policy philosophy that developed out of the Keynesian revolution of the 1930s and its subsequent empirical applications. Moreover, these models embodied the view that aggregate demand expansion, from almost any level, would permanently create new jobs. When that expansion carried the economy beyond "full employment" there would be a cost in terms of higher inflation but only a one-time increase in inflation, so that there existed a permanent trade off between sustainable levels of inflation and employment. The stagflation of the 1970s required a thorough conceptual overhaul of economic thinking and policymaking. Monetarism, and new insights into the effects of anticipatory expectations on economic activity and price setting, competed strongly against the traditional Keynesianism. Gradually the power of state intervention to achieve particular economic outcomes came to be seen as much more limited. A consensus gradually emerged in the late 1970s that inflation destroyed jobs, or at least could not create them. This view has become particularly evident in the communiques that have emanated from the high-level international gatherings of the past quarter century. That inflation could reduce employment was a highly controversial subject in the mid-1970s when introduced into communique language drafts. At the meetings I attended as Chairman of the Council of Economic Advisers, the notion invariably induced extended debates. Today in similar communiques such language is accepted boiler plate and rarely the focus of discussion. This shift in attitudes and understanding provided political support in 1980 and thereafter for the type of monetary policy required to rebalance the economy. Despite waxing and waning over the decades, a deep-seated tension still exists over government's role as an economic policymaker. This tension is evident in Congressional debates, campaign rhetoric, and our ubiquitous talk shows. Return to top It should not be a surprise that the very same ambiguities and conflicts that characterize the rest of our political life have their reflection in the nation's current view of its central bank, the Federal Reserve. With regard to monetary policy, the view or at least the suspicion still persists in some quarters that an activist, expansionary policy could yield dividends in terms of permanently higher output and employment. Nonetheless, there is a grudging acceptance of the degree of independence afforded our institution, and an awareness that unless we are free of the appropriations process that our independence could be compromised. It is generally recognized and appreciated that if the Federal Reserve's monetary policy decisions were subject to Congressional or Presidential override, short-term political forces would soon dominate. The clear political preference for lower interest rates would unleash inflationary forces, inflicting severe damage on our economy. Notwithstanding, the central bank has not been immune from the suspicion and lack of respect that has come to afflict virtually all institutions in our society since the traumas of Vietnam, Watergate, and the destabilizing inflation in the 1970s. The Federal Reserve's most important mission, of course, is monetary policy. I wish I could say that there is a bound volume of immutable instructions on my desk on how effectively to implement policy to achieve our goals of maximum employment, sustainable economic growth, and price stability. Instead, we have to deal with a dynamic, continuously evolving economy whose structure appears to change from business cycle to business cycle, an issue I shall return to shortly. Because monetary policy works with a lag, we need to be forward looking, taking actions to forestall imbalances that may not be visible for many months. There is no alternative to basing actions on forecasts, at least implicitly. It means that often we need to tighten or ease before the need for action is evident to the public at large, and that policy may have to reverse course from time to time as the underlying forces acting on the economy shift. This process is not easy to get right at all times, and it is often difficult to convey to the American people, whose support is essential to our mission. Because the Fed is perceived as being capable of significantly affecting the lives of all Americans, that we should be subject to constant scrutiny should not come as any surprise. Indeed, speaking as a citizen, and not Fed Chairman, I would be concerned were it otherwise. Our monetary policy independence is conditional on pursuing policies that are broadly acceptable to the American people and their representatives in the Congress. Augmenting concerns about the Federal Reserve is the perception that we are a secretive organization, operating behind closed doors, not always in the interests of the nation as a whole. This is regrettable, and we continuously strive to alter this misperception. If we are to maintain the confidence of the American people, it is vitally important that, excepting the certain areas where the premature release of information could frustrate our legislated mission, the Fed must be as transparent as any agency of government. It cannot be acceptable in a democratic society that a group of unelected individuals are vested with important responsibilities, without being open to full public scrutiny and accountability. To be sure, if we are to carry out effectively the monetary policy mission the Congress has delegated to us, there are certain Federal Reserve deliberations that have to remain confidential for a period of time. To open up our debates on monetary policy fully to immediate disclosure would unsettle financial markets and constrain our discussions in a manner that would undercut our ability to function. Nonetheless, we continue to look for ways to expand the flow of information to the public without compromising our deliberations and purposes. We have recently commenced to announce all policy actions immediately (federal funds rate changes as well as discount rate changes) and have expanded the minutes of the Federal Open Market Committee. For many years, the Federal Reserve has maintained what we trust is a highly sophisticated day-by-day, near real-time, evaluation of the American economy and, where relevant, of foreign economies as well. We are able, partly through our twelve Reserve Banks, to monitor continuously developments in the real world. The information supplied about local conditions by the directors of the Reserve Banks has been frequently useful in identifying emerging national trends and in evaluating their underlying regional implications. Return to top The issues with which we are confronted differ in urgency over time. Inflation concerns were not a dominant factor in economic forecasting in the 1950s and early 1960s, for example. Since the late 1970s, however, such concerns have become an important element in policymaking. More recently inflation has been low, but its future course remains uncertain. The development of comfortable product, but tight labor, markets has been a crucial factor in short-term economic forecasts of recent months a phenomenon for which there is scant historic precedent. There is, regrettably, no simple model of the American economy that can effectively explain the levels of output, employment, and inflation. In principle, there may be some unbelievably complex set of equations that does that. But we have not been able to find them, and do not believe anyone else has either. Consequently, we are led, of necessity, to employ ad hoc partial models and intensive informative analysis to aid in evaluating economic developments and implementing policy. There is no alternative to this, though we continuously seek to enhance our knowledge to match the ever growing complexity of the world economy. At different times in our history a varying set of simple indicators seemed successfully to summarize the state of monetary policy and its relationship to the economy. Thus, during the decades of the 1970s and 1980s, trends in money supply, first M1, then M2, were useful guides. We could convey the thrust of our policy with money supply targets, though we felt free to deviate from those targets for good reason. This presumably helped the Congress, after the fact, to monitor our contribution to the performance of the economy. I should add that during this period we maintained a fully detailed analysis of the economy, in part, to make sure that money supply was still emitting reliable signals about the state of the economy. Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy. Thus, to keep the Congress informed on what we are doing, we have been required to explain the full complexity of the substance of our deliberations, and how we see economic relationships and evolving trends. There are some indications that the money demand relationships to interest rates and income may be coming back on track. It is too soon to tell, and in any event we can not in the future expect to rely a great deal on money supply in making monetary policy. Still, if money growth is better behaved, it would be helpful in the conduct of policy and in our communications with the Congress and the public. In the absence of simple, summary indicators, we will continue our detailed evaluation of economic developments. As we seek price stability and maximum sustainable growth, the changing economic structures constantly present more analytic challenges. I doubt the tasks will become any easier for the Federal Reserve as we move into the twenty-first century. The Congress willing, we will remain as the guardian of the purchasing power of the dollar. But one factor that will continue to complicate that task is the increasing difficulty of pinning down the notion of what constitutes a stable general price level. When industrial product was the centerpiece of the economy during the first two-thirds of this century, our overall price indexes served us well. Pricing a pound of electrolytic copper presented few definitional problems. The price of a ton of cold rolled steel sheet, or a linear yard of cotton broad woven fabrics, could be reasonably compared over a period of years. But as the century draws to a close, the simple notion of price has turned decidedly ambiguous. What is the price of a unit of software or a legal opinion? How does one evaluate the price change of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient changes so radically. Indeed, how will we measure inflation, and the associated financial and real implications, in the twenty-first century when our data using current techniques could become increasingly less adequate to trace price trends over time? So long as individuals make contractual arrangements for future payments valued in dollars, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money. No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output and hence of price that is recognizable to producers and consumers and upon which they will base their decisions. Doubtless, we will develop new techniques of price measurement to unearth them as the years go on. It is crucial that we do, for inflation can destabilize an economy even if faulty price indexes fail to reveal it. But where do we draw the line on what prices matter? Certainly prices of goods and services now being produced our basic measure of inflation matter. But what about futures prices or more importantly prices of claims on future goods and services, like equities, real estate, or other earning assets? Are stability of these prices essential to the stability of the economy? Return to top Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy. The public examination of Federal Reserve actions extends well beyond our stewardship of monetary policy. Our overall management of the Federal Reserve System should, and does, come under considerable scrutiny by the Congress. Since we expend unappropriated taxpayer funds, we have an especial obligation to be prudent and efficient with the use of those funds. I am not particularly concerned about the one-third of our annual $2 billion budget that is expended to provide financial services to the private sector in competition with other providers. Such services include the clearing of checks, the operation of the Fedwire system, and the processing of automated clearing house payments. We are reimbursed for those services, and at competitive prices still make a reasonable profit for the Treasury. If we became inefficient and uncompetitive, we would be priced out of the market, and eventually out of that line of business. An additional one-sixth of our expenses are for providing services to the Treasury and other agencies of government for which we are subject to reimbursement with appropriated funds. For the remainder, which mainly covers monetary policy, supervision and regulation of banks, and currency operations, we have to be especially diligent, for there is no external arbiter. The rapidly changing technologies of recent years are pressing us to review thoroughly our structure and operations. We have already engaged in major consolidations of operations when such consolidations have been made cost effective by the newer technologies. Although in my experience the Federal Reserve System has been responsible, efficient, and has performed well, the rapidly changing external environment frequently requires us to rethink our role and mission. Even where we can be competitive, it is not the role of a government agency, especially one vested with an unsurpassable credit rating, to seek out all available market opportunities. Accordingly, where specific priced services have become effectively and competitively provided by private sector suppliers, the Federal Reserve needs to reassess whether the extent of our participation in those services fulfills a reasonable public purpose. There are, of course, certain services that the Congress has, and will in the future, deem appropriate for us to subsidize. But these areas presumably will remain circumscribed. As a step in our periodic reassessment, a special committee of Federal Reserve Board governors and Reserve Bank presidents has been set up to review our priced services operations and other Systemwide activities. Another step has been to engage outside accounting firms to audit the Federal Reserve Board and the twelve Reserve Banks. We had been quite satisfied with the Board as general auditor of the Reserve Banks since 1914. But the range of activities and the reach of the Federal Reserve in recent years requires us to address the perception that we are auditing ourselves without the full arm's length relationship deemed appropriate in today's environment. Finally, the substantial changes under way in bank risk management are pressing us to continuously alter our modes of supervision and regulation to keep them as effective and efficient as possible. Most importantly, all of our recent initiatives, especially the strengthening of the payments system and supervision, are critical to a central mission of the Federal Reserve, to maintain financial stability and reduce and contain systemic risks. This mission is an extension of our monetary policy. Our country can not enjoy the long-run "maximum employment and stable prices" objectives we are given for monetary policy if the financial system is unstable. In this regard, the successes that most please us are not so much the visible problems that we solve, but rather all the potential crises that could have happened, but didn't. Doubtless, the most important defense against such crises is prevention. Recent mini-crises have identified the rapidly mushrooming payments system as the most vulnerable area of potential danger. We have no tolerance for error in our electronic payment systems. Like a breakdown in an electric power grid, small mishaps create large problems. Consequently, we have endeavored in recent years, as the demands on our system have escalated (we clear $1-1/2 trillion a day on Fedwire), to build in significant safety redundancies. This has been costly in terms of equipment and buildings. Along with our other central bank colleagues, we are always looking for ways to reduce the risks that the failure of a single institution will ricochet around the world, shutting down much of the world payments system, and significantly undermining the world's economies. Accordingly, we are endeavoring to get as close to a real time transaction, clearing, and settlement system as possible. This would sharply reduce financial float and the risk of breakdown. Meaningful progress has already been made in this direction. This evening I have tried to put current central banking issues in historical context. Monetary arrangements, including central banks, naturally are under constant scrutiny and criticism. This is no less true of the Federal Reserve in 1996 than of the gold standard in 1896. Central banks need to respond patiently and responsibly to the commentary, and we need to adapt to changing circumstances in markets and the economy. A democratic society requires a stable and effectively functioning economy. I trust that we and our successors at the Federal Reserve will be important contributors to that end.

D.C.

https://www.federalreserve.gov/boarddocs/speeches/1996/19961203.htm

Clearinghouses and risk management

Governor Edward W. Kelley, Jr.

At the 1996 Payments System Risk Conference, Washington, D.C.

It is a pleasure to be with you this morning to discuss private-sector payments risk management in our changing financial environment. Private-sector clearing arrangements, including numerous clearinghouses, are an integral part of the payment system in the United States, and now is an appropriate time to encourage further debate and action on important risk management issues. I would like to bring some perspective to this topic by first, outlining some of the broad forces affecting clearinghouses and other parts of the payment system; second, discussing the major risks and the different risk management techniques that clearinghouses employ; third, raising some key questions about risk controls for different types of clearing arrangements; and finally, highlighting recent policy developments in this area. First, the broad forces shaping clearing arrangements both now and in the future. To date, the growth of electronic payments has been an important force shaping our clearing systems. In the large-value sector, the volume and value of electronic payments has continued to grow rapidly, heavily influenced, of course, by the growth of trading in the international markets, and electronics now dominates this activity. In the small-value sector, ACH payments have also grown rapidly, although from a very low base. An important issue is how fast electronic payments will grow in the near-to-medium term and whether they will begin to replace the check as one of the major payment instruments in the retail sector. If this were to happen, there would presumably be corresponding adjustments in our clearing institutions. One important phenomenon affecting the risks in check clearinghouses has been the trend toward converting different types of larger-value payments to electronic form, and processing these payments in environments with stronger risk controls. The latest example of this trend came earlier this year when the money settlements for most stock trades were converted from checks and drafts to Fedwire fund transfers. Another broad force that will affect clearinghouses is the advent of interstate branch banking. Most directly, widespread interstate branch banking over the next few years could increase the number of checks and other items cleared as so-called "on-us" items, reducing the number of payments flowing through clearinghouses, and indeed, through correspondent banks and the Federal Reserve. To some extent, such developments would tend to reduce interbank risk in the payment system. As interstate banks participate in more and more clearinghouses, they may also begin to look for higher and more uniform risk management standards in the clearinghouses around the country. In addition, interstate banking may well contribute to pressures to reduce the number of clearinghouses, with those remaining covering broader, even nationwide, geographic areas. We have already seen evidence of this trend in check clearinghouses in a number of regions. Of course, the prospects for clearinghouse consolidation would be heavily influenced by the degree to which economies of scale exist in current operations and whether new technologies and organizational techniques can be brought to bear on traditional practices. Return to top To the extent new clearing arrangements and technologies are adopted, there may also be significant new opportunities to improve risk management. For example, technological improvements and declining computing costs might help increase the use of automated risk management systems in clearing arrangements for retail payments, which have not traditionally employed strong risk controls. Let me turn to the types of risks that exist in clearing arrangements. One key type of risk is interbank credit risk. In the clearinghouse context, this is the financial risk that a bank or other participant will default on its payment or settlement obligations to the clearing group when they are due, causing losses to other participants. There is also liquidity risk. If settlement payments are delayed or otherwise not completed on time, one or more banks in a clearinghouse, for example, might be short of cash, which would prevent the completion of other transactions. The significance of this risk will usually depend on the size and intraday timing of clearinghouse settlements. Further, there are legal risks. There has been much discussion over the past few years, for example, of the need for strong legal foundations for bilateral and multilateral netting arrangements, including clearinghouse arrangements. I would note that significant progress has been made on this front in the United States with changes in netting law. There are also operational and security risks. Concerns about these risks are often greatest in the wholesale payments area, where the dollar flows are largest. However, operational and security breakdowns could pose very significant problems for retail payment systems, especially if large numbers of payment items were involved. You are no doubt aware of publicity surrounding these risks in connection with the development of emerging payment technologies, such as stored-value cards, Internet-based payment systems, and new retail banking technologies generally. Discussions have centered, for example, on the use of the Internet or other "open networks" for delivering banking services and making payments. One can also imagine that clearinghouses or other multilateral arrangements might be developed for some of these new payment technologies. Risks related to operational and security failures could be a very important component of the risks faced by such new clearing arrangements. I would urge that all banking organizations take these operational risks seriously and act with great prudence in evaluating and managing them. A fundamental concern of central banks, of course, is systemic risk. This can involve risks that one bank's problem will spill over onto others, risks that whole clearing systems may cease to operate effectively, and even more broadly, risks that unexpected events will destabilize the banking system as a whole. It is this type of concern that has motivated a sustained effort by the international central banking community in a number of areas. In the payment field, concerns about systemic risk have led central banks to call for reductions in settlement risk, in general, and stronger clearing and settlement arrangements, in particular. The usual focus of concern is on payment systems that are explicitly designed to handle large-value payments. But the same types of risk credit, liquidity, legal, operational, and systemic are often present in clearing systems for smaller-value payments; only the scale of risk is different. It is also important to recognize that although the average dollar value of daily clearings and settlements may be relatively low, the number of checks or other items in the daily clearings may be very high. These payments may include paychecks, corporate payments to suppliers and securities holders, and other routine but very important payments whose completion we take for granted as part of the normal functioning of the economy. Thus, a settlement failure in a check clearinghouse, for example, could be extremely disruptive to the banking system, and even to segments of the economy more broadly, if many thousands of payments were returned or not completed on time. Let me turn now to a variety of techniques for risk control commonly used by clearinghouses in the wholesale financial markets to control interbank credit, liquidity, and systemic risks. These are clearinghouses for payments and securities as well as futures, options, and foreign exchange contracts. Their risk control techniques often encompass membership standards relating to operational expertise and creditworthiness. Most clearinghouses also designate a risk manager along with a risk management committee. Further, the clearing rules and operational systems typically implement some type of credit and liquidity risk limits, such as caps on net debit positions. For many clearinghouses, limits are enforced in real time. In some, certain limits are enforced after the fact, provided members remain in good standing. To ensure that settlement can occur even if a member defaults, clearinghouses typically employ backstop liquidity resources, such as margin or collateral deposits, participants' funds, and lines of credit. Loss sharing rules are intended to allocate credit losses unambiguously to surviving members, in the event that a participant's default would not be covered by its collateral or other funds at the clearinghouse. For what we traditionally think of as "small-value" payments, however, the clearinghouse has often been treated simply as a convenient way to exchange bundles of checks and other items and to administer settlements. Although a handful of check and ACH clearinghouses use some more advanced risk controls, the vast majority seem to take the approach that if anything goes wrong, clearinghouse participants will take two aspirin and return payments in the morning. While this point of view is not necessarily wrong, and may be quite cost-effective when amounts at risk are low, it also should not be defended simply because we have always done things this way. Instead, we need to ask ourselves some basic questions about the reasons why risks and risk controls have been viewed differently for different clearinghouses. First, does the type of instrument determine the types of risk and appropriate controls? For example, is one method of risk control appropriate for credit transfers and another for debit transfers? Second, does the technology matter? Is one type of risk control appropriate for paper-based instruments such as checks, and another for similar transfers made electronically, such as ACH debit transfers? Is one type of risk control appropriate for batch-processing systems and another type for real-time processing systems? Third, does scale matter? Are stronger risk controls appropriate if large systemic risks are generated by huge daily values of payments and settlements, but not if daily payment flows are relatively small? If you believe that only the amount of dollars at risk matters, what about the potential disruption in the banking system that could occur if one of the larger check clearinghouses were to fail? Fourth, do the participants matter? Is one standard of risk control appropriate for highly creditworthy institutions and another for less creditworthy institutions? Should risk controls vary by institutional type of participant? In addition, since many institutions participate in more than one clearinghouse, do we get too limited a picture of risk and risk management if we analyze clearinghouses individually? Return to top Finally, are there minimum risk standards that all clearing houses should meet or do risk profiles vary across different organizations, making such standards awkward and unnecessary? And if there are minimum standards, can they be met by different risk control methods? Without endeavoring to give specific answers to these questions this morning, let me turn to the development of central bank policy toward private clearinghouses over the past few years. Clearinghouse risks and many of the risk management techniques I have mentioned have been analyzed in a series of reports prepared by the G-10 central banks and published by the Bank for International Settlements. The key report on clearing arrangements that employ multilateral netting was the 1990 "Report of the Committee on Interbank Netting Schemes," known as the Lamfalussy Report. This report depended heavily on earlier work on netting arrangements by the Federal Reserve and the U.S. banking industry. In late 1994, the Board formally adopted the Lamfalussy Minimum Standards for controlling risk in netting systems by incorporating it into our policy statement on large-dollar payments risk. At that time, however, the Board announced that, for the time being, it would not apply the large-dollar policy statement to clearinghouses that use batch processing operations. Since the Board's large-dollar policy statement was adopted, we were pleased to see that the NOCH/NACHA Task Force on Settlement Risk Management has used the type of risk analysis employed in the policy statement to evaluate the risks in check and ACH clearinghouses. This is an important step in establishing a firm consensus on the risk analysis framework that is appropriate for such private-sector clearinghouses. The report does not identify significant systemic risks or call for more highly developed risk controls in these clearinghouses. However, the report does urge the private sector to take more definitive steps to evaluate the risks in clearinghouses and stronger actions to strengthen risk management where needed. The emphasis in the report on voluntary efforts by the banking industry and clearinghouse associations is welcome. In the United States, it has often been the clearinghouse participants themselves that have designed and pressed for the most innovative and effective tools for risk management. We would welcome further steps along these lines. The Task Force Report also raises the question of whether the Federal Reserve could offer improved net settlement services to the banking industry that would also serve to reduce interbank risk. This is a question that I believe has become increasingly important, particularly with the advent of interstate branch banking and the growth of clearinghouses offering nationwide services. Currently, the Federal Reserve offers a same-day net settlement service to national clearinghouses in which banks use the Fedwire to execute the fund transfers necessary to complete their multilateral net settlements each day. This model has three very significant virtues from the point of view of risk control: It is fast; it has the strongest real-time risk controls employed by the Federal Reserve; and settlement is normally final soon after the settlement process starts. These characteristics greatly speed up the final transfer of funds and the successful completion of settlement. The result is that the duration of interbank risk exposures, typically overnight exposures in check clearinghouses, is shortened significantly. Over the past few years, these risk reduction benefits have helped increase interest in the Federal Reserve's national same-day settlement service. Some have asked whether the beneficial risk reduction characteristics of the national Fedwire-based net settlement service can be retained but offered in a somewhat more convenient format. The Federal Reserve staff is actively reviewing this possibility along with the Board's general risk policies relating to smaller-dollar clearing arrangements. I expect that there will be good progress to report on these issues relatively early next year. Let me conclude with three observations. First, it is encouraging that the banking industry is becoming more sensitized to issues of risk in check, ACH, and similar clearing arrangements. Too often, our attitude has been that if there are strong risk controls on the large-dollar systems, we can simply ignore risk in the rest of the clearing infrastructure. Second, those with a direct stake in individual clearing systems need to act on their growing sensitivity to risk and address the need to strengthen risk management. The types of concerns that I outlined above need to be analyzed in the context of specific clearinghouses and specific control systems. We believe that this is an important job of the owners and participants. Finally, we need to ask ourselves why, in an era when electronic technology has made instantaneous communication and final fund transfers possible, we still incur the risks of conducting multilateral interbank settlements that are not final until the next banking day. Clearly we should not allow long-standing operational conventions to dictate the design of interbank settlements, and thereby increase payment-system risk, if these conventions are now obsolete and improvements are possible. As I noted, the Federal Reserve is actively analyzing clearinghouse developments and reviewing its small-dollar netting policies. To date, the work of the private sector has been encouraging. However, it is clear that the job of improving risk management is not finished. All of us have more work to do. Indeed, improving payment risk management in a changing environment is an ongoing responsibility.

D.C.

https://www.federalreserve.gov/boarddocs/speeches/1996/19961125.htm

Supervisory and regulatory responses to financial innovation and industry dynamics

Governor Susan M. Phillips

At the BAI Seminar on Regulatory Policy Changes, Washington, D.C.

Supervisory and Regulatory Responses to Financial Innovation and Industry Dynamics It is a pleasure to be here and participate in your discussions of current changes in bank regulatory policies. In your program this morning, you have already heard a lot about the Federal Reserve Board's Regulation Y proposal, and I will not repeat the details. Still, I think it would be useful to highlight two of the key principles the Board identified in seeking comment on Regulation Y two principles that I believe illustrate a more general restructuring of the Board's overall approach to regulation and supervision. These principles also animate the Board's recent proposals in the section 20 area and elsewhere. First, in proposing to expand the laundry list of activities in which a bank holding company may engage, the Board stated that, to the extent possible, the restrictions a bank holding company faces in conducting a specific activity should be no more onerous than those applying to an insured depository institution conducting the same activity. Second, in proposing to streamline the application process for bank holding company acquisitions, the Board stated that review of those applications should focus on how the proposal would affect the organization as opposed to serving as a vehicle for comprehensively evaluating and addressing supervisory issues at the applicant organization. Put another way, well-managed, well-capitalized institutions who have demonstrated that they are serving the needs of their community should have greater freedom to expand and innovate. I believe these two principles reflect the Board's recognition that technological and financial innovation is remaking the banking industry. Regulatory and supervisory approaches should also adapt to the changing environment. Return to top Regulation Y and Section 20 Initiatives As you know, the dramatic changes which have swept over the banking industry the past several years have also affected the entire financial services industry. Advances in telecommunications and computer technology have provided banks and their competitors with new and more efficient opportunities to expand regionally, nationally and globally. At the same time financial innovation has enabled institutions to fine tune and expand product lines and activities. The structure of the industry is also changing as the recent wave of mergers among larger organizations and the advent of true interstate banking speed the pace of industry consolidation. Despite this consolidation, however, competition in the industry is increasing. Smaller banks are becoming more efficient, and the competition with nonbank financial institutions is growing steadily. As a result of all these changes, the banking industry is now competing with an increasing number of financial service providers on a dynamic playing field. Unfortunately, the nation's banking laws have not been updated to reflect this changing environment. As the risks of holding company activities become increasingly transparent, it becomes increasingly anomalous that the banking laws severely restrict two banking related activities underwriting and dealing in securities and insurance. Except for some types of insurance underwriting, these activities are generally no more risky, and often significantly less risky, than many activities in which banks routinely engage namely, lending. Although I remain hopeful that Congress will address some of these issues, we at the Board are trying to provide banks as much latitude, commensurate with risk, that existing laws allow. We have recognized in the Regulation Y proposal that if banks may engage in a given activity, there is no logic in prohibiting or imposing any additional restrictions on that activity when it is conducted in a holding company. Similarly, in the section 20 arena, the Board recently eliminated a restriction on cross-marketing and employee interlocks between a bank and a securities affiliate, and substantially reduced restrictions on director and officer interlocks. Here again, part of the calculus was whether there was anything unique to a section 20 subsidiary that warranted firewalls that are not imposed on any other type of bank affiliate engaged in activities posing similar risks. The answer was generally, "No." I expect that the Board will be asking the same question when we undertake a more comprehensive review of the other firewalls in the coming months. While there may be legal or reputational risks unique to affiliation with a securities firm that justify some of the existing restrictions, many firewalls may not address such risks and thus can no longer be justified. Finally, I believe that these issues will be hotly debated in the coming months as Congress considers repealing not only section 20 of the Glass-Steagall Act, but all of the Glass-Steagall Act. I expect Congress will also consider the repercussions of the Comptroller's decision of last week to allow a bank's operating subsidiaries to engage in activities forbidden the bank. Here the debate becomes more subtle not about whether an activity is appropriate for a bank holding company, but rather where in the bank holding company it should be conducted. In particular, should riskier activities be conducted in separately capitalized affiliates of banks, or as subsidiaries of banks, under the federal safety net and with the benefit of the federal subsidy inherent in that safety net. There also appear to me some unanswered legal and accounting questions relating to the separateness of a bank and its operating subsidiary. Return to top Changes in Bank Supervision As the industry changes, the nature of supervision is also undergoing significant change. The traditional goals of supervisors remain the same that is, to ensure the safety and soundness of financial institutions so that they do not become a source of systemic risk, pose a threat to the payment system, or burden taxpayers with unnecessary losses. However, supervisors are looking to accomplish these goals in ways that are more risk-focused and burden-sensitive. An example of such change that was put forward in the Regulation Y proposal is the reassessment of the role of an application in the supervisory process. This step parallels recent Congressional action to eliminate the prior approval process entirely for strong bank holding companies wishing to engage in previously approved nonbanking activities legislation proposed and supported by the Board. In the past, the Board may have tended to use the application process to address and resolve supervisory issues at the applicant organization sometimes involving matters that had little to do with the proposed acquisition or activity. The Board's proposal to limit the application process to ensuring that it assesses only the pertinent issues relating to an application, including the statutory and regulatory factors the Board must consider, clearly signals that the Board intends to reduce the role of the application process as a supervisory tool. Supervisory matters that are not significant to an organization's overall well-being or which are not related to a specific application under consideration are best addressed through other, more targeted supervisory actions. These tools include the advancement of guidance on sound banking practices, enhanced off-site surveillance, the move to risk-focused examinations, and an increasing emphasis on improving market transparency through better public disclosure of the risk profiles of financial institutions. I believe these initiatives are more efficient and effective in meeting supervisory goals and would like to briefly discuss some initiatives in each of these areas. First, we are expanding efforts to promote sound banking practices. Through our evaluations of many institutions, we as regulators are in a unique position to identify and promote sound risk management practices within the industry. In earlier years, supervisors used guidance for relatively narrow purposes typically to advise examiners or bankers on interpretations of existing regulations or procedures for compliance. Today, guidance is moving away from narrow, compliance-oriented prescriptions toward the identification and dissemination of sound practices for managing the risks involved in the various activities banks conduct. Please note my emphasis on "sound," not "best," practices. Sound practices reflect those minimum principles to be employed to ensure that the activity is conducted prudently. Best practice, in my view, can and does occur in institutions of every size, shape and level of sophistication, but supervisors should focus on sound practices and leave the determination of what is "best" to the judgment of individual institutions. For example, since 1993, the U.S. banking agencies have issued a series of instructions, policy statements, and examination manuals stressing the importance of managing various risks posed by the institution's activities. The most notable example is the guidance issued in 1993 and 1994 on derivatives and trading activities. This initiative has continued to encompass investment activities, and, this summer, interagency guidance on sound practices for managing interest rate risk exposures was issued. I believe the dissemination of this type of guidance is a good example of supervisors adding value, and we expect to continue to emphasize this approach in the future. We are also attempting to make greater use of the banking industry's sound, internally developed models and practices in risk management in order to reduce regulatory burden and to improve the effectiveness of our supervision. For example, the agencies' newly revised capital standards for market risk related to a bank's trading activities will permit large trading banks to use their internal "value-at-risk" models to calculate their capital requirements for market risk, subject to examiner oversight and a few regulatory constraints. Another area where regulators are innovating is in the examination process. The cornerstone of the bank supervisory process is the verification of prudent practices and financial condition through on-site examinations, coupled with off-site surveillance. Traditionally, on-site examinations have focused on compliance issues and verifying the condition of the institution at a point in time by reconciling accounts, testing individual transactions and performing ratio analysis. This process is changing. For example, examiners are now placing more emphasis on evaluating the soundness of a bank's process for managing and controlling risks. Testing the soundness of the institution's risk management and internal control processes provides greater assurance of an institution's soundness on an ongoing basis. To fully implement this approach, this year the Federal Reserve began assigning a formal rating to risk management in our examination reports. This change reflects the increasing importance we place on sound management and adequate internal controls. To improve the examination process, the Federal Reserve and other banking agencies are also emphasizing more pre-visitation planning in order to better identify those areas of a bank's activities that pose the greatest risk. In other words, the examination scope is now more customized and focused. We are also making greater use of computer technology in the examination process, using automated systems that permit examiners to download data from a bank's computer, analyze portfolios on their personal computers, and identify concentrations and other characteristics within the bank's loan portfolio. As a result, examiners should be able to reduce materially the amount of time they spend on manual operations and should be able to devote more time to identifying and evaluating risks. I would emphasize, however, that although we are revising the on-site examination process, the Board remains convinced of its fundamental importance. Although performance-based regulation has much to commend it, and is already used as a tool by all the agencies, we find that our examiners generally detect problems before they manifest themselves in lower capital ratios, downgrades from rating services, or criticism from outside auditors. Simply put, there really is no substitute for a hands-on review by persons unbeholden in any way to the institution. Another area of innovative change relates to surveillance activities between on-site examinations. Traditionally, surveillance efforts have relied on standardized ratios and screens compiled through regulatory reporting forms. However, those screens are sometimes not flexible or comprehensive enough to provide a true profile of the bank's risk. One enhancement we are making to our surveillance activities is to tailor the information we collect to the bank's activities, including making greater use of the bank's own internal management reports and the results of internal risk models. In recent years, for example, the Federal Reserve has begun to collect internal loan classification reports prepared by most of our larger banks, as well as other information generated by their internal risk management systems. Such changes merely reflect the evolving nature of bank activities and the improved procedures banks have for measuring risks and managing their activities. As with examinations, disclosure practices of the past also focused narrowly on the financial condition of the institution at a point in time, using conventional accounting and regulatory measures. Today, however, disclosures are expanding to include a description not only of the level of risk taken by the company but also of management's philosophy for managing and controlling risk. This improved transparency enhances market discipline and rewards prudent management. We have already done much to improve disclosures for derivatives and market risks, and we will continue to urge better and more broadly based disclosure on all of an institution's major activities and exposures. Return to top Conclusion I hope this review of supervisory initiatives illustrates that supervisors are making concerted efforts to keep pace with market practices and financial innovations. Just as innovation poses new challenges to the industry, it also poses challenges to supervisors. I believe the Board is responding and is making significant progress in adapting its existing supervisory regimes. But as we make changes to our own processes to make regulations less burdensome and to allow increased activities by banking organizations, we are finding that the supervisory process is becoming more important, not less important, in meeting our responsibilities for a safe and sound banking system. Thank you.

D.C.

https://www.federalreserve.gov/boarddocs/speeches/1996/19961121.htm

The transformation of the U.S. banking industry and resulting challenges to regulators

Governor Laurence H. Meyer

At the Ohio Bankers Day Convention, Columbus, Ohio

The Transformation of the U.S. Banking Industry and Resulting Challenges to Regulators Good morning. It is a pleasure to be here on Ohio Bankers Day. The over-riding theme of my remarks is the profound transformation the banking industry has undergone over the last 15 years or so and the challenges that these changes pose to bank regulators. At the end, I hope to have time to take some questions and learn where you think the banking industry is going, and how consistent with our responsibilities regulators can promote a more efficient, resilient, and profitable financial services industry. I plan to learn as much or more from you as you learn from me. The Role of Banks Let me begin with a few observations about the importance of the banking industry in the economy and why banking receives such special attention in terms of regulation. Banks, like other financial intermediaries, pool and absorb risks for depositors and provide stable sources of investment and working capital funds for nonfinancial industries. Banks also provide a unique mix of services among all financial intermediaries, including a "safe haven" for small, unsophisticated investors through insured deposits, an important source of funds for small borrowers who often have limited access to other sources of external finance, a smoothly functioning payments system that allows financial and real resources to flow relatively freely to their highest-return uses, a conduit for monetary policy, and a backup source of liquidity for any sector in temporary difficulty through its access to the discount window. Throughout all the changes of the past, and through all the changes to the banking industry in the foreseeable future, banks will continue to perform these important functions, and a goal of bank regulators is to make sure that there is a healthy banking industry to do so. Return to top The Rationale for Bank Regulation But there are two particularly important characteristics of the banking system that demand our attention as regulators indeed, are critical to understanding why there are bank regulators. First, banks have access to a government safety net through deposit insurance, the discount window, and payment system guarantees. This gives the government a direct stake in keeping bank risks under control, just like a private insurance company has a stake in controlling the risks of policyholders. Because deposit insurance can never be fully and accurately priced, it is necessary for us to monitor and sometimes to act to control bank risks in order to protect the potential call on taxpayers. It is also important to understand that an unintended consequence of the safety net is that it creates or augments incentives for some banks to take additional risks. That is, the safety net creates moral hazard incentives to gamble because the safety net and potentially taxpayers may absorb most of the losses if the gamble fails. Deposit insurance gets in the way of the depositors signaling a bank when it takes excessive risks. The second characteristic of banks that requires the special attention of regulators is that banks are capable of being the conduits of systemic risk and crisis in financial markets. A breakdown of the payments system or other contagion effect that hampers the ability of banks to intermediate credit flows could have serious adverse consequences for the economy, again requiring the special attention of regulators to bank risks. The challenge is to strike a balance in regulation so that, on the one hand, taxpayers are protected, extensions of the safety net are avoided, and moral hazard incentives are mitigated without, on the other hand, undermining the competitiveness of the banking industry and its ability to take risk, and therefore damaging the entity the regulators are trying to protect. Return to top The Evolution of Bank Regulation Although this rationale for bank regulation has not changed, in the last decade and a half there has been a significant evolution in approach of regulators toward maintaining the safety and soundness of the banking industry. From the 1930s through most of the 1970s, regulators focused on keeping the banking industry safe and sound by protecting banks from competition and by limiting the activities in which they could participate. This meant, for example, prohibiting interstate banking, restricting the rates that banks could pay on deposits, and preventing commercial banks from competing in other product markets, such as investment banking. During this period, the financial services industry was segmented into separate entities providing commercial banking, investment banking, insurance services, etc. This separation was largely due to legislative and regulatory decisions. A consequence of the separation was that firms in each segment of the financial services industry were protected from competition from firms providing the other services. Starting in the late 1970s, the changed economic environment along with advances in technology, financial innovations, and globalization resulted in increased competition to U.S. banks by thrifts, nondepository financial institutions, foreign banks, and the capital markets. Higher and more variable interest rates, and the accompanying increased yield sensitivity of depositors and borrowers, contributed to the development of money market mutual funds as alternatives to bank deposits and the growth of finance companies and commercial paper as substitutes for bank loans. The increase in external competition brought a swift response from both banks and their regulators. Banks responded to the challenge by expanding in ways that they could, also taking advantage of improvements in technology and applied finance. They expanded their roles as intermediaries through off-balance-sheet activities such as securitization, back-up lines of credit and derivatives, and, in the process, substituted fee income for some of the interest income lost through competition with other financial intermediaries. In addition, banks sought expanded powers to help them compete, including being able to cross state borders, set their own deposit rates and account types, and by the late-1980s expand into securities underwriting activities. Regulators responded to the new environment by reducing the regulatory burden on banks and allowing them to compete on a more level playing field with nonbanking firms. That is, the new market realities required a reorientation in emphasis from protecting banks from competition to giving banks the opportunity to compete not only with other banks but with nonbank competitors as well. By allowing banks to enter other states, set their own prices, and engage in other than traditional banking activities, the orientation of regulators evolved toward protecting the safety net while allowing banks to deliver financial services to the public efficiently, profitably, and with sufficient capital to be protected against unforeseen events. Return to top Structural Change in the Banking Industry As a result of this process of structural change, the banking industry of the mid-1990s in many ways hardly resembles that of the late 1970s and early 1980s. Some of the major changes that I want to focus on are the increased consolidation of the industry, the decline in traditional banking services as a result of increased outside competition, the expansion in bank powers, including the move into nontraditional activities to offset the competition for their traditional products, the increased emphasis on risk management in response to the increased complexity of financial instruments and practices, and the evolution of capital standards and capital positions to keep abreast of the changing risk profiles of banking organization. Consolidation in the banking industry One of the most obvious and dramatic changes is the consolidation of the banking industry. The number of independent banking organizations by which I mean top-tier holding companies plus unaffiliated banks has shrunk by more than one-third since the late 1970s, from more than 12,000 to fewer than 8,000. The percentage of banking assets controlled by organizations with more than $100 billion has about doubled, and is now close to a fifth of all U.S. banking assets, while the percentage of banking assets in banking organizations with less than $100 million in assets has dropped by half, from about 14 percent to 7 percent of industry assets. Much of the consolidation is a direct outgrowth of the removal of geographic restrictions on bank branching and holding company acquisitions by the individual states, a process that is now being extended by the Reagle-Neal Interstate Banking and Branch Efficiency Act of 1994. This deregulation encourages the banking industry to become more efficient at serving the public’s needs by allowing the efficient competitors to succeed and manage more of the industry’s resources. The banking industry has also become stronger through the geographic diversification of risks made possible by interstate banking. Importantly, the interstate expansion of large banks does not mean the end of small banks. Past experience has consistently shown that when large banking organizations enter a new local market by acquisition, the existing small banks that are efficient can compete successfully and maintain their market shares and profitability. We fully expect thousands of small banks to remain in business even after nationwide branching is fully implemented. The emergence of, and response to, increased outside competition: a decline in traditional banking and the growth of nontraditional activities Over the last 15 years, there has also been a substantial increase in competition to the U.S. banking industry from capital markets, less-regulated domestic financial institutions, and foreign institutions. As a result, U.S. banks have lost substantial market shares of many of the asset and liability categories that were the mainstay of traditional banking. However, these declines in market share for banks in traditional product lines do not suggest that the banking industry itself is in decline. After factoring into the analysis the rapid expansion of nontraditional off-balance-sheet activities, research suggests that the banking industry continues to grow, although not as fast as financial markets as a whole. The banking industry, for example, has grown at about the same rate as GDP and the new products of the banking industry such as derivative contracts and other off-balance-sheet activities have skyrocketed. The most important indicators of whether the banking industry is in decline measures of financial performance are even more positive. The banking industry is profitable, able to raise capital in financial markets, and has a relatively high market-to-book ratio. These performance indicators also suggest that resources will continue to flow into the industry, rather than out of the industry. The evidence taken as a whole suggests that the banking industry is weathering the increase in outside competition and is competing well against it. Return to top The expansion of bank powers The powers of banking organizations also grew dramatically over this time period in two different ways. First, in the early 1980s, the Monetary Control Act gave banks the right to set their own deposit interest rates and offer new types of accounts, such as household transactions accounts that paid market-based interest rates. Another major way in which banking organization powers expanded over this period was the increase in the number of banking activities permitted to nonbank affiliates of bank holding companies. Regulators allowed bank holding companies to enter more and more product markets over this time period. Bank holding companies can now have separately capitalized subsidiaries that offer investment advice, provide discount brokerage services, and underwrite both debt and equity securities, albeit under restricted circumstances. The market also played a large part in blurring the old distinctions between banks and nonbanks, as other financial services companies began to offer more products with characteristics close to those of bank deposits and loans. Again, the regulatory shift in orientation was in large part a reaction to the market banks were given more power to compete with nonbanks in part because nonbanks were figuring out better ways to compete against banks. It is also notable that over time banks have taken much greater advantage of the powers they already had. As I mentioned earlier, banks greatly increased their use of off-balance-sheet guarantees to follow some of their loan customers who chose to borrow their funds elsewhere, and banks were also active players in the new derivative products of the 1980s and 1990s. Increased emphasis on risk management and the growing importance of market risk Despite these many changes, the core business of banking has remained the measurement, acceptance, and management of risk, although a number of important developments over the last 15 to 20 years have improved the abilities of banks to perform these functions. The most notable developments are in the area of market risks. Derivative contracts such as futures and swaps are essentially new lines of business for banks in the last decade and a half, which allow banks to measure, accept, and manage market risks to a much greater extent than in the past. In the 1970s, banks primarily measured, accepted, and managed the credit risks of illiquid loans and dealt little with market risks other than minimal asset-liability duration matching. The rapid developments in market risk tools have facilitated an expansion of the core business of banking to put an increased emphasis on market risks, but banks are nonetheless still primarily in the same core business of measuring, accepting, and managing risks. However, it is important to recognize that having access to improved risk management technologies does not necessarily make banks safer. Despite the improvements in the abilities of banks to understand and control risks, the risks of the institutions themselves ultimately also depend importantly on the incentives of bank managers and owners to control risks, and on the economic environment in which they operate. There is little benefit, and perhaps net costs, in having a bank manager know how to measure, accept, and manage risks accurately if this ability is used to take excessive risks that are largely borne by the federal safety net and potentially by taxpayers. Similarly, when the economic environment turns against bank investments, many banks will become risky and some will fail, even if they have managed their risks fairly well. Return to top The source of the large number of bank failures in the 1980s and the dramatic improvement in the health of the banking system in the 1990s These caveats are well illustrated by comparing the circumstances of U.S. banks in the 1980s versus the 1990s. During the 1980s, bank failures were increasing, and by the end of the decade banks were failing at the rate of about 200 per year. Even greater problems were experienced by the savings and loan industry. These problems have been largely attributed to two factors. First, when banks or savings and loans get into very low or negative capital positions, the moral hazard problem I discussed earlier may become more severe. There is a possibility of purposely taking on additional risks to gamble their way out of trouble. When there is little capital at risk, the owners get much of the benefits if the gamble pays off, and the safety net and taxpayers bear most of the losses if the gamble fails. Second, the 1980s saw a number of turbulent economic changes. These included fluctuations in interest rates and inflation rates, swings in the prices of commercial real estate and junk bonds that could not be easily forecast, and regional recessions that caused significant numbers of problem loans. These changes caused damage at many financial institutions, particularly those in geographically undiversified positions without sufficient capital to protect themselves. Given the poor condition of many banks as late as 1991, it is amazing how healthy the banking industry is now, having written off most of its bad assets, raised large amounts of capital, and returned to profitability, likely having its fifth straight year of record profits in 1996. Bank failures have now retreated to at or near single digits per year. Clearly, this turnaround is too rapid to be completely accounted for by technical and financial innovations in the measurement, acceptance, and management of risk, or by improvements in the diversification and capitalization of banks. Changes in attitudes toward risk taking brought about by the higher capital standards and other factors, and changes in the economic environment have also played important roles in the improved health and wealth of the banking industry. The evolution of capital standards and capital positions The final development I will discuss is the evolution of the financial capital positions of U.S. banks, since capital is the cornerstone of defense against bank risks. Capital serves two functions in this regard. First, it helps improve the incentives of banks to keep their own risks under control, reducing moral hazard incentives to take those risks that are largely imposed on others. Second, capital is a buffer stock available to absorb risks and economic shocks without creating bankruptcy costs and systemic problems associated with the failure of financial institutions. A goal of capital requirements along with bank supervision and quality risk management by the banks themselves is to make the safety net a moot issue for most banks. That is, by having enough capital available to absorb potential losses and having both the bank and supervisor carefully monitoring and acting to control portfolio risks, the moral hazard incentives of the safety net and the vulnerability of the deposit insurance funds can be kept to a minimum. It is similarly true that the more we can do to keep risk to the safety net under control using capital and other tools, the more powers we can safely grant to banks without placing undue stress on the safety net or meaningfully expanding safety net protection to other activities. At the end of the 1970s, capital regulation was relatively ad hoc and depended largely on the judgment and discretion of the individual bank’s supervisors. Starting in 1981, regulations required banks to hold capital equal to a flat percentage of their balance sheet assets. The next refinement was based on Basle Accord risk-based capital standards adopted in 1988 and implemented starting in 1990 requiring banks to hold different amounts of capital depending on the perceived credit risk of different on- and off-balance-sheet assets. In addition, to reduce discretion in the enforcement of the standards and the closure of capital-impaired banks, Congress included "prompt corrective action" provisions in the FDIC Improvement Act of 1991 (FDICIA). Under prompt corrective action, or PCA, banks with capital ratios below certain threshold values are subject to increasingly severe mandatory and discretionary sanctions. Finally, risk-based capital standards which originally only covered credit risks are now being extended to cover market risks. The process by which the new market risk standards were arrived at is indicative of the new orientation toward incentive-based regulation, allowing well capitalized, efficient banks to compete and imposing costs more selectively on undercapitalized, poorly managed banks. The standards also permit banks that are more efficient at monitoring and controlling their risks to hold less capital than inefficient banks. These regulatory standards are much like what the market would do in the absence of the safety net. The new standards, which apply to banks with substantial trading, allow banks to use their own internal models of risk that are employed in their everyday operations to determine the capital requirements on their trading books. This approach also reflects a new effort to develop refinements in regulatory standards in cooperation with the industry, in part by better understanding the "best practices" that are evolving in the industry and using these as a basis for regulatory standards across the industry. A cumulative effect of the many changes in capital regulation in the 1980s and early 1990s, as well as other factors, is that banks have much higher capital ratios today than they did 15 years ago, and even 5 years ago. This is especially true at the largest banking organizations. For the banking industry as a whole, the equity-to-assets ratio rose from less than 6 percent at the end of the 1970s to over 8 percent in the mid-1990s. For the largest banking organizations, the capital ratio rose from less than 4 percent to over 7 percent. Return to top The Implications of the Transformation of Banking for Bank Regulation We should not be too sanguine about bank capital, however. While the current capital standards are significant improvements over what they replaced, they are still based on broad one-size-fits-all rules. Moreover, the market has begun to focus more on the capital-risk trade-off: no large bank or parent banking organization, for example, has AAA long-term debt, and only a handful are rated AA, despite the capital ratios I just quoted. Banks at the cutting edge are risk rating their loan portfolios and internally allocating capital to them for management and profitability analysis. Such allocations are superior ways of developing capital allocation for individual banks. Perhaps we will be able in the future to harness banks’ internal capital allocations for regulatory purposes. Indeed, the reason for choosing the topics I have discussed thus far is that these structural changes represent an on-going process and are going to continue to challenge us in the future. In the final portion of my remarks, I will try to identify some of the most important challenges that regulators will face as a result of these changes. Maintaining local competition in the face of continued bank consolidation First, with regard to future banking industry consolidation, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 essentially expands the existing regional compacts to the nation as a whole, and overturns the McFadden Act prohibition on interstate branching. Interstate branching to almost all the states is permitted as of June 1, 1997. The removal of these artificial barriers to trade is beneficial and will likely improve efficiency and diversification of risks in the banking industry. The exact future structure of the banking industry is unknown, but presumably will be driven not just by the removal of legal barriers to competition, but by shifts in technology, efficiency, and risk diversification. The firms with the greatest managerial efficiencies are expected to take over those with the lowest efficiencies and improve them. Research in banking suggests that these differences in managerial efficiency are much larger than any scale and scope economies. Various models predict that several thousand banking organizations are likely to disappear under nationwide banking, but that the remaining banks will still number in the thousands, as small community banks that serve their constituents well are likely to remain in business. There appear to be two key challenges to regulators regarding consolidation. The first is to be sure that there is adequate competition from banks and nonbanks in local banking markets. Research has suggested that high local market concentration leads to prices that are unfavorable to bank customers low deposit rates for retail depositors and high loan rates for small business loans. High concentration may also lead to reduced managerial efficiency, as the price cushion provided by market power allows a "quiet life" for managers in which relatively little effort is required to be profitable. Insuring an adequate amount of local-market competition is essential to avoid these potential problems. The second challenge brought on by consolidation is to make sure that mergers and acquisitions do not create excessive risks. In this regard, it is important that capital be sufficient to cover any problems during the transition period when the banks and systems are learning to work together, on top of the normal risks of ongoing operations. The interaction of bank powers and bank structure The future expansion of banking organization powers also raises some challenges to regulators. Indeed, financial reform will likely be a high priority of the next Congress, perhaps including repeal of Glass-Steagall. One of the results of financial reform, along the lines of the bill Congressman Leach introduced last session, would be the emergence of financial services holding companies that could include both commercial and investment banks. There is also a prospect that banks might be able to expand into insurance activities as well. This would take to a perhaps logical conclusion the recent blurring of the lines between financial services firms. Whether or not the Glass-Steagall Act is repealed, we face the challenges of insuring that the proposed recent expansion of bank powers through section 20 subsidiaries does not inadvertently expand the safety net protection afforded to banks to protect other, previously nonbank, activities. This would give an unfair subsidy to banking organizations. While there is no perfect system for allowing financial intermediaries to gain the most from the synergies of joint production while avoiding expansion of the safety net, there are several steps that seem likely to keep this problem under control. First, we need to be sure to require plenty of capital in the bank to keep the value of access to the safety net low. Second, we need to provide reasonable insulation of the bank from the risks of the nonbanking enterprises. The Board believes that the best way to do this is by placing new activities in holding company subsidiaries, rather than in the bank itself or its subsidiaries. The further the separation from the bank, the better is the insulation. A third safeguard to protect the bank and prevent the expansion of the safety net subsidy is the adoption of prudential limitations through firewalls and rules that prohibit or limit certain bank and affiliate transactions. While firewalls may temporarily bend under stress, they nonetheless serve a useful purpose. On the other hand, we must strike a balance and not make the firewalls so rigid that they would eliminate the economic synergies between the banks and their affiliates. In this spirit, the Board last month made an effort to modify firewalls to allow banks to achieve efficiency gains with respect to security underwriting in Section 20 affiliates without creating excessive risks. The issue of what bank structure is appropriate and prudent in light of expanded banking powers is a particularly controversial one. While the Board’s view that the expanded powers should be carried out only in subsidiaries of the bank holding company was incorporated into the Congressman Leach’s unsuccessful financial modernization bill in the last Congress, this preference is not shared by all parties to this debate. Some stress the costs associated with the holding company structure and question its benefits from a safety and soundness perspective and, as a result, favor either allowing the new activities to be carried out in a subsidiary of the bank itself or at least allowing banks an option with respect to structural form. Return to top Staying up-to-date in the supervision of bank risk management as financial products and practices evolve There will undoubtedly be further developments in the ways that banks perform their core functions of risk measurement, acceptance, and management as markets continue to evolve improved "best practices" in dealing with market and credit risks. This evolution will continue to challenge regulators to keep capital standards and other risk monitoring and control mechanisms from falling too far behind. One particular challenge is that the continued development of derivative products and other means of managing risks can also allow bank employees to take excessive risks and hide them from supervisors and perhaps from the owners of the bank. It is difficult for regulators to quantify these risks, and even more difficult to design risk-based deposit insurance and risk-based capital systems that accurately incorporate these risks. In response, regulators will need to stick with capital as the cornerstone of defense against bank risks, both to reduce moral hazard incentives and to provide a buffer stock to absorb losses. A challenge will be to continue to update the capital standards in line with current or not-too-out-of-date risk measurement techniques. Expansion of the recently implemented "internal models" type of approach may be helpful in this regard, using, as I noted earlier, banks’ own risk measurements to help set their capital requirements. In addition, many of the techniques used to quantify and control market risks may be transferable for use in quantifying and controlling credit risks in the future. The task of measuring capital and risks can also be made easier if bank portfolios are made somewhat more transparent. Increased transparency would also facilitate market discipline a highly desirable goal in our rapidly changing financial environment. A problem here is that it is not always clear how to best encourage transparency. For example, partial market value accounting may involve more costs than benefits. However, it seems clear that this is an issue that will remain on our plates for the foreseeable future. In addition, the capital standards can and should be augmented by bank supervisors in individual cases. The risk-based capital standards and prompt corrective action rules are, and will remain, only minimum capital guidelines for normal circumstances. Supervisors need to require additional capital when banks are explicitly taking additional risks that are not captured by the guidelines, or when bank risks are excessively opaque and it is too difficult to determine if excessive risks might be undertaken. To accomplish this, it is important to continue to examine banks on a regular basis. There is simply no market substitute for the type of information that can be gathered under the auspices of a bank examination with access to the complete records of a bank. However, as financial transactions become more complex, supervisors cannot be expected to monitor every detail. Increasingly, supervisors will focus on banks’ risk management procedures. Banks will have to convince supervisors that they have prudent risk management procedures and policies and that the bank follows them. Increasingly, supervisors will emphasize your process of risk management and control, and proof that you are using those techniques, in order to determine whether your capital is adequate for your risk profile and procedures. Reducing the burden of regulation and increasing the uniformity in regulation across banking agencies While recent banking legislation significantly reduced the regulatory burdens on the banking industry, we all realize that keeping the costs of supervision and regulation low is an important on-going task for all parties. It is particularly important for the federal banking agencies to continue efforts at improved cooperation with each other, including standardization of certain policies and procedures and data collection. In short, we must try to reap the potential benefits of multiple regulators in terms of encouraging innovation and providing checks and balances on regulatory excess, without incurring the potential costs of "competition in laxity" and excessive overlap and duplication of efforts. I am optimistic that this can be done, perhaps by augmenting the role of the FFEIC. Conclusion I want to leave some time for questions, so let me just sum up with a few comments. The banking industry has been transformed over the last decade and a half, and regulators have tried to adopt policies to allow the industry to become stronger, more efficient, and better able to meet the competition without placing undue stress on the safety net. This represents a change from an earlier regulatory philosophy of protecting banks from competition, and I think the change is in the right direction. We still face a lot of challenges from the continuing evolution and consolidation of the industry, but we will do our best at trying to let the strong, efficient banks compete, so long as they are not imposing significant risks on the safety net and taxpayers.

Ohio

https://www.federalreserve.gov/boarddocs/speeches/1996/19961118.htm

Banking in the global marketplace

Chairman Alan Greenspan

At the Federation of Bankers Associations of Japan, Tokyo, Japan

Banking in the Global Marketplace It is again a pleasure to be here in Tokyo at the invitation of the Bank of Japan. Tokyo's role as one of the world's key financial centers depends importantly on the confidence of the international community in the Bank of Japan and the great respect in which it is held. As Tokyo continues to evolve as a financial center, the role of the Bank of Japan will correspondingly increase, as well. Frankly, when I think about the potential for serious disruption in international financial markets, I take considerable comfort from the high degree of cooperation between the Bank of Japan and the Federal Reserve, with contacts at all levels and covering a full range of issues very strong and getting stronger. The last time I addressed this distinguished group was four years ago. Since then, of course, much has happened in international financial markets. The processes of growth, globalization, and innovation have continued. Extraordinary advances in risk measurement and risk management and in sensitivity to risks in general have been perhaps the most salutary aspects of that ongoing evolution. Other developments, including the financial problems of banks and other financial institutions in Japan, but also, for example, the Mexican peso crisis and Barings, were less favorable and have posed serious challenges. Nonetheless, I believe that from a long-term perspective the responses to those challenges will prove to have had important positive consequences as well. One notable response to the developments in international financial markets came from the leaders of the G-7 countries. At the G-7 Summit meeting in Halifax in 1995 and again in Lyon in 1996, they set in motion a series of initiatives aimed at promoting stability in international markets. I will say a few words about some of those initiatives in a few moments, because I think they deserve our attention. However, before doing so, I will focus my remarks this afternoon on the nature of supervision, the sharing of risks between the private and the public sector, and the implications for the behavior of banks and bank supervisors. Return to top The nature of supervision and the sharing of risks It is useful, I believe, to begin by reminding ourselves just why there is bank supervision and regulation. At bottom, of course, is the historical experience of the effects on the real economy of financial market disruptions and bank failures, especially when the disruptions and failures spread beyond the initial impetus. But it is critical also to understand some key implications of the safety net provided to banks in most countries, involving in the case of the United States, for example, a system of deposit insurance, payment guarantees, and discount window credit. Since the safety net makes bank creditors feel safer, the banking system is larger, more stable, and more able to take risk and extend more credit than otherwise would be the case. In the process, banks contribute significantly to economic growth. The safety net, however, also engenders a disconnect between risk-taking by banks and banks' cost of capital and funding and hence has made necessary a degree of supervision and regulation that would not be necessary without the safety net. That is, regulators are compelled to act as a surrogate for market discipline since the market signals that usually accompany excessive risk-taking are substantially muted, in part because the costs of deposit insurance or of access to the safety net more generally do not, and probably cannot, vary sufficiently with risk. The problems that arise from the short-circuiting of the pressures of market discipline have led us increasingly to understand that the ideal strategy for supervision and regulation is to simulate the market responses that would occur if there were no safety net, but without giving up the basic requirement that financial market disruptions be minimized. These implications of the safety net highlight the dilemma of the regulator. How do we preserve an innovative and flexible banking system without either exposing the taxpayer to excessive potential costs or the financial system to excessive systemic risk? Return to top In addressing these issues, it is important to remember that many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process, providing savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more efficient allocation of resources and contributing importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times certainly since Renaissance goldsmiths discovered that lending out deposited gold was feasible and profitable. Of course, this same leverage and risk-taking also greatly increase the possibility of bank failure. Without leverage, losses from risk-taking would be absorbed by a bank's owners, virtually eliminating the chance that the bank would be unable to meet its obligations in the case of a "failure." Some failures can be of a bank's own making, resulting, for example, from poor credit judgments. For the most part, these failures are a normal and important part of the market process and provide discipline and information to other participants regarding the level of business risks. Other failures can result from, and contribute to, the rare episodes of severe economic or market turmoil that affect broad segments of an economy and are not the consequence of the imprudence of individual banks. Because of important roles that banks and other financial intermediaries play in our financial systems, such failures could have large ripple effects that spread throughout business and financial markets at great costs. Over time, societies have concluded that leverage and intermediation are essential to economic performance, but also that some bank failures could have unacceptable economic costs. In response, central banks were created and were accorded new responsibilities, and what we now call prudential regulation evolved. In the United States, these initiatives took the shape of the creation of the Federal Reserve in 1913 after several financial panics in the late 19th and early 20th centuries, and of federal deposit insurance and a broadened role for bank supervisors in the 1930s. While the responses in other countries were often less overt, they were generally still significant in their effects. This expanded role of governments, central banks, and bank supervisors implies a complex approach to managing and even sharing the risks of failure between governments and privately owned banks. Some of what central banks do might be termed "shaping" or reducing some kinds of risks, primarily by providing liquidity in certain situations to reduce the odds of extreme market outcomes, in which uncertainty feeds market panics. Traditionally this was accomplished by making discount or Lombard facilities available, so that depositories could turn illiquid assets into liquid resources and not exacerbate unsettled market conditions by forced selling of such assets or calling loans. Similarly, open market operations, in situations like that which followed the 1987 stock market crash, satisfy increased needs for liquidity that otherwise could feed cumulative, self-reinforcing, contractions across many financial markets. Return to top Guarding against systemic problems also has involved, on very rare occasions, an element of more overt risk-sharing, in which the government or more accurately the taxpayer is potentially asked to bear some of the cost of failure. Activating such risk-sharing quite appropriately occurs at most maybe two or three times a century. The willingness to do so arises from society's judgment that some bank failures may have serious adverse effects on the entire economy and that requiring banks to carry enough capital to avoid any risk of failure under all circumstances itself would have unacceptable costs in terms of reduced intermediation. If banks had to absorb all financial risk, then the degree to which they could leverage, of necessity, would be limited, and their contribution to economic growth, modest. Risk-sharing encourages leverage and intermediation. Eliminating risk-sharing and asking banks to remove the possibility of failure would lead to a much smaller banking system. To attract or at least retain equity capital, a private financial institution must earn, at a minimum, the overall economy's rate of return, adjusted for risk. In their management of market or credit risk, well-run banks carefully consider potential losses from most possible market outcomes and hold sufficient capital to protect themselves from all but the most extreme situations. But banks and other private businesses recognize that to be safe against all possible risks implies a level of capital on which it would be difficult, if not impossible, to earn a competitive rate of return. On the other hand, if central banks or governments effectively insulate private institutions from the largest potential losses, however incurred, increased laxity could be costly to society as well. Leverage would escalate to the outer edge of prudence, if not beyond. Lenders to banks (as well as their owners or managers) would learn to anticipate central bank or government intervention and would become less responsible, perhaps reckless, in their practices. Such laxity would hold the potential of a major call on taxpayers. And central banks would risk inflationary instabilities from excess money creation if they acted too readily and too often to head off possible market turmoil. In practice, the policy choice of how much, if any, of the extreme market risk that government authorities should absorb is fraught with many complexities. Yet we central bankers make this decision every day, either explicitly or by default. Moreover, we can never know for sure whether the decisions we made were appropriate. The question is not whether our actions are seen to have been necessary in retrospect; the absence of a fire does not mean that we should not have paid for fire insurance. Rather, the question is whether, ex ante, the probability of a systemic collapse was sufficient to warrant intervention. Often, we cannot wait to see whether, in hindsight, the problem will be judged to have been an isolated event and largely benign. Return to top Thus, governments have been given certain responsibilities related to their banking and financial systems that must be balanced. We have the responsibility to prevent major financial market disruptions through development and enforcement of prudent regulatory standards and, if necessary in rare circumstances, through direct intervention in market events. But we also have the responsibility to assure that private sector institutions have the capacity to take prudent and appropriate risks, even though such risks will sometimes result in unanticipated bank losses or even bank failures. Our goal as supervisors, therefore, should not be to prevent all bank failures, but to maintain sufficient prudential standards so that banking problems which do occur do not become widespread. We try to achieve the proper balance through official regulations, as well as through formal and informal supervisory policies and procedures. To some extent, we do this over time by signalling to the market, through our actions, the kinds of circumstances in which we might be willing to intervene to quell financial turmoil, and conversely, what levels of difficulties we expect private institutions to resolve by themselves. The market, then, responds by adjusting the cost of capital to banks. Throughout most of this century, we have made our decisions largely in a domestic context. However, in recent decades that situation has changed markedly for many countries and is rapidly changing for all. While failures will inevitably occur in a dynamic market, the safety net not to mention concerns over systemic risk requires that regulators not be indifferent to how banks manage their risks. To avoid having to resort to numbing micromanagement, regulators have increasingly insisted that banks put in place systems that allow management to have both the information and procedures to be aware of their own true risk exposures on a global basis and to be able to modify such exposures. The better these risk information and control systems, the more risk a bank can prudently assume. Return to top Role of banks The use of new technology and instruments in rapidly changing financial markets means that some bank balance sheets are already obsolescent before the ink dries. They are not even necessarily indicative of risk exposures that might prevail the next day. In such a context, the supervisor must rely on his evaluation of risk management procedures as a supplement to and in extreme cases, a substitute for balance sheet facts. As the 21st century unfolds, the supervisors' evaluation of safety and soundness, of necessity, increasingly will be focussed on process, and less on historical records. Well-functioning risk management systems are necessary, but not sufficient, for taking on greater risk. Banks must also have the capital resources to absorb the inevitable losses that result from risk-taking and still remain solvent. Thus, banks are required to maintain both reserves consistent with expected losses and capital sufficient to absorb the vast majority of unexpected losses that experience and data suggest could occur, but whose timing and size are not predictable. Determination of appropriate capital levels is not just a regulatory concern. Increasingly, bankers are treating the determination of proper capital levels as integral to the meeting of shareholder goals. Shareholder value is maximized, almost surely, when long run risk adjusted return on equity is maximized. One method of quantifying the risk adjusted return is to measure returns net of expected losses against the capital that should be allocated to a transaction to reflect that transaction's risk. Some bankers are doing exactly that: quantifying risks, allocating sufficient capital to cover those measured risks, and then trying to focus on those lines of business for which risk adjusted returns to allocated capital are the highest. It does not matter whether the bank concentrates on low risk, low capital business, or on high risk, high capital business, only that it concentrates on businesses for which it has a comparative advantage, that is, businesses that earn an above average rate on its internally allocated capital, after provisions for expected losses. Regulators should take notice of this emerging business philosophy for a bank that properly measures its risks and allocates capital to those risks is well on its way to being a safe and sound bank, as well as one that meets its shareholders' objectives. Most bankers in recent years have been confronted with an increasing complexity of financial instruments and transactions. However, these complexities would not have arisen in actual market circumstances without the technological advances that also allowed these risks to be measured and managed. Banks can now quantify the dimensions of risks for instruments and transactions that we could only conceptualize a few years ago. Consider just two examples of what risk quantification permits today: securitization and the day-to-day control of market risk in a portfolio of complex derivative contracts. In both of these cases, risk quantification is a prerequisite to informed risk-based pricing. Moreover, the comparison of the risk-based price to current market conditions is critical to management decisions regarding withdrawing, cutting back, or expanding a bank's scale of activity in specific credit markets. Return to top The largest U.S. banking organizations are moving into new areas of risk evaluation for internal management purposes, including the quantification of credit risk. They have or are developing procedures for allocating capital against various types of loans, based on estimates of credit risk for various categories. For example, in middle market lending at these institutions, a first step is to classify loans into various rating categories usually 1 to 10, with 1-rated loans being equivalent to triple-A securities and 10-rated loans about to be written off as loss. Periodically, each loan is re-evaluated and re-categorized if necessary. Such categorizations have been done for some time, but the more sophisticated banks are going an important step beyond this point: They are using historical data to estimate the mean and variance of defaults and actual losses on each grade of loan. The result can be interpreted as attempting to infer the loss probability distribution for each category or subportfolio of loans, and for the entire loan portfolio. Consider how such information can be used. Estimates of expected losses and the probability distribution of unexpected losses are critical for pricing credits correctly and deciding whether competitive market rates thus imply withdrawing, cutting back, or expanding various types of credit. A prerequisite, however, is a judgment by management as to the proper amount of capital to allocate to each of the subportfolios or risk categories so that risk-adjusted rates of return can be calculated. These capital allocations, as I noted, are for internal management, not regulatory, purposes. But I am impressed with what they teach us, the regulators, and what they imply for regulatory capital. The internal capital allocations used by banks in the United States range from less than 2 percent for highly rated loans to 20 percent or more for the most risky credits. In addition, credit enhancements, such as most junior positions in securitized loan pools, can have theoretical capital allocations that widen still further the range of appropriate internal capital allocations. Compare this wide range of internal capital allocations with the 8 percent, one-size-fits-all Basle standard. In fact the average risk-based capital ratio for large U.S. banks approaches 12 percent, far above the 8 percent minimum. Nonetheless, consider the anomaly of a bank with a 12 percent risk-weighted capital ratio being viewed by the public as having a strong capital position when the bank's own capital allocation models suggest that it should have 15 percent capital, or more. The supervisor, I believe, is not being misled in most such cases, and should be capable of making the appropriate judgmental adjustments. Moreover, the markets clearly make such adjustments: I note that banks with very high risk-based capital ratios still may not achieve triple-A ratings on their debt, and some do not even have single-A ratings. We at the Federal Reserve are beginning a review of the internal credit risk-capital allocation models of major U.S. banks in order to understand better the strengths and weaknesses of these models. We already know, however, that there has been an irreversible application of risk measurement technology without which banks would not be able to design, price, and manage many of the newer financial products, like credit derivatives. These same or similar technologies can and are beginning to be used to price and manage traditional banking products. Return to top The widespread adoption of these techniques lies in the future, but, as I suggested earlier, some forms of risk quantification are now being used by banks to enhance shareholder values. Unfortunately, some bankers believe that new technologies and the growth of some activities will reduce their franchise values by driving down spreads. On the other hand, the byproducts of these new technologies include lower underwriting expenses and the more accurate estimation of probable losses. These byproducts act to offset the effects of increasing competition created by the new technologies, both by raising profits on existing operations and by opening up opportunities with customers previously not served. More generally, and of much greater importance, rapidly changing technology is broadening and deepening financial markets while inevitably enhancing competitive pressures. In one sense this trend has been with us since the industrial revolution, but it has clearly accelerated in recent years in banking markets. Because the hot hand of competition is always putting pressure on us, we in our darker moments wish it would just go away. I very often succumbed to such melancholy when I was in the private sector. But we are wrong. Competition is the force which keeps us on our toes, makes us better and more productive, and creates higher market values for our banking institutions, just as it does for other firms. Competition is what has raised our standards of living for generations. Technological change and the accompanying competition are irreversible, and those banks unwilling or unable to adapt to them will lose market share and suffer lower risk adjusted rates of return. But the banks that embrace the cost-cutting and risk-reducing effects of the technology will, in my judgment, tend to find it a rewarding experience. Return to top Role of supervisors As financial markets change, regulators too must adapt to the new technology, and, in this regard, some important lessons are being learned. Technological change is not the sole province of the private sector. For example, the private sector, for a considerable time, has been accustomed to product planning cycles in which the planning of the replacement product is begun, if not well along, by the time a new product is being introduced. Similarly, regulators are beginning to understand that the supervision of a financial institution is, of necessity, a continually evolving process reflecting the continually changing financial landscape. This is not a fault, but rather a description of an appropriate regulatory process. Indeed, given our own long lead times, we must begin designing the next generation of supervisory procedures even while introducing the latest modification, much as you are forced to do for your own products. Increasingly, the new supervisory techniques and requirements try to harness both the new technologies and market incentives to improve oversight while reducing regulatory burden, burdens that are becoming progressively obsolescent and counterproductive. This is becoming especially true in evaluating the capital adequacy of banks. One example is the recent consensus reached by international banking regulators to use internal model approaches for measuring market risks at banks and allocating regulatory capital to those risks. Looking further down the road, the Federal Reserve Board has been studying an alternative capital allocation process for market risk, the so-called pre-commitment approach. This methodology would provide market and other financial incentives for banks to choose their own capital allocations for trading risk that they believe are consistent with their own risk management capabilities, as well as with regulatory objectives. With the Board's encouragement, the New York Clearing House Association is organizing a pilot study of the pre-commitment approach. The next natural step is to begin to review ways to harness, for supervisory purposes, the banks' own models for the measurement of credit risk. The decision to craft a bank's capital requirements for trading activities around accepted and verifiable internal risk measures was an important step in the supervision and regulation of large, internationally active banks. It is all the more noteworthy because it recognizes the importance of both quantitative and qualitative criteria in the measurement and management of trading risks. As risk management techniques evolve for other bank activities, supervisors will need to understand the new procedures and how they affect overall banking risks. Time and again, though, events are demonstrating that despite the complexity of transactions and the alleged sophistication of management systems, it is the lack of simple basic policies and controls that so often lead to problems at banks. Fortunately, in many cases, the technology that has enabled institutions to design complex new products also provides the techniques with which the resulting risks can be identified, measured, and controlled. Management also must have the knowledge and motivation to employ these techniques to ensure that risks are adequately contained. We must never forget that no matter how technologically complex our supervisory systems become, the basic unit of supervision on which all else rests remains the human judgment of the degree of risk on a specific loan, based on the creditworthiness and character of a borrower. If those credit judgments are persistently flawed, no degree of complexity of supposed risk dispersion or elegance of credit models will help. Return to top Today's technology allows us to measure risk in ways that were unthinkable a decade ago. The next decade will likely produce further dramatic changes. But already today, we can seriously begin to contemplate a regulatory quantification of what we mean by the soundness of a financial institution. Recall that while the objective of bank regulation and supervision is to assure a minimum level of prudential soundness, the precise meaning of soundness has always been tenuous and ill-defined. This is why judgment has been, and will continue to be, a critical component of prudential supervision. However, the technology and techniques banks have developed, and are developing, allow us greatly to improve that judgment by constructing measures of soundness in probability terms. If we can obtain reasonable estimates of portfolio loss distributions, soundness can be defined, for example, as the probability of losses exceeding capital. In other words, soundness can be defined in terms of a quantifiable insolvency probability. Moreover, one can conceive of definitions of soundness that go beyond simply the probability of insolvency to encompass also the level and variability of losses to a deposit insurance fund in the event of insolvency. All of these approaches, however, require the regulators to establish targets regarding acceptable failure rates or an insurance fund's exposure to potential losses. Note that a bank could meet any particular quantitative soundness standard by increasing its capital or by reducing the riskiness of its portfolio. I do not mean to suggest that we have reached the point at which we can now establish quantitatively precise soundness standards. We have not. These procedures are in their infancy and are hampered by the lack of micro data bases which have to be laboriously constructed at, or by, individual banks. Moreover, ascertaining relevant probabilities, the basis of an evaluation of soundness, presupposes an estimation of the shape of these distributions, arguably the most difficult aspect of this process. The technical methodology is also changing with experience and with conceptual progress in the academic and professional communities. Within the United States, the Federal Reserve and other bank supervisors are placing growing importance on a bank's risk management process and are strengthening our supervisory procedures, where necessary, to assist examiners in identifying management weaknesses and strengths. We are also working to develop supervisory tools and techniques that utilize available technology and that help supervisors perform their duties with less disruption to banks. These improvements range from software designed to download data about a bank's loan portfolio to an examiner's personal computer, to simply more thoughtful reviews of internal management reports. Such automation enhancements will permit examiners, themselves, to analyze more efficiently the various concentrations within loan or investment portfolios and, therefore, help them to identify the underlying risks and discuss those risks with bank management. Countries in which supervisors conduct on-site examinations or otherwise review specific loans or loan portfolios may find such technology particularly useful. Within the United States, the growing volume and complexity of transactions, particularly at the largest institutions, require such productivity enhancements and other modifications to our supervisory procedures in order for us to do our job effectively. For example, rather than evaluate a high percentage of a bank's loans and investment products by reviewing individual transactions after the fact, we will increasingly seek to ensure that the management process itself is sound, and that adequate policies and controls exist. While still important, the amount of transaction testing, especially at large banks, will decline. However, supervisors everywhere should expect bank boards of directors and senior managements to perform their leadership and oversight roles. By themselves supervisors cannot expect to detect or prevent every unsound practice, nor to ensure that all weak management processes are improved. We can expect our banking systems to be sound only by ensuring that directors and managers provide guidance regarding their appetite for risk; that they bring personnel to the bank with the integrity and skills to do the job; and that they monitor compliance with their own directives. Encouraging and promoting sound qualitative risk management and internal controls has been and should remain a high priority of bank supervisors. Indeed, it is as important, in my view, as the development of quantitative prudential standards. Return to top Supervisory cooperation Let me turn briefly to the G-7 initiatives to which I referred earlier. The communique from the Lyon Summit meeting in June stated four objectives designed to promote stability in international financial markets. First, cooperation among the authorities responsible for the supervision of internationally active financial institutions should be enhanced. The largest banks in every country and even many of the smaller banks are now actively engaged in international markets. Their organization charts cut across national boundaries. Therefore, it has become important that supervision also be seen in an international context. Increasingly also their organization charts cut across the sometimes subtle boundaries between banks and other financial and non-financial institutions. In order to maintain financially sound institutions and financial markets, cooperation across countries and between bank and nonbank supervisors is desirable and, at times, essential. To be sure, bank supervisors from G-10 countries have been actively working together in the Basle Committee on Banking Supervision and its predecessor committees since the mid 1970s. Supervisors of securities firms have also been working together in IOSCO. But it is only fairly recently, and in part a result of the encouragement by G-7 leaders in Halifax, that banking and securities supervisors have been trying to coordinate their efforts. This is not an easy task, since the philosophy of, and motivation for, supervision of banking activities are different from the supervision of securities operations. What kind of supervisory information needs to be shared among supervisors, which supervisors need to be involved, and in what circumstances, are difficult questions but properly are being addressed. The Joint Forum, which includes insurance regulators as well, is struggling with these questions and with the complex question of how financial conglomerates ought to be supervised. I am confident that these various efforts will help to promote a safer global marketplace, but they are not the last word. As our supervisory systems mature, so too must our international cooperation develop further. Return to top Second, risk management should be strengthened and transparency should be improved. I do not intend to say more than I already have about risk management, but I would like to emphasize the importance of transparency, by which I mean in this context enhanced reporting and public disclosure of financial activities. Market and supervisory pressures have led to substantially more, as well as more meaningful, public disclosure of risk positions and risk management procedures. I might note also that, earlier this year, a central bank working group under the able chairmanship of Shinichi Yoshikuni of the Bank of Japan recommended a reporting system that, when fully implemented, will add considerably to our knowledge of derivatives market activities. This and other initiatives will enable financial market participants as well as supervisors to gain more information and a better perspective with which to evaluate the activities of individual firms. It is only through adequate disclosure that market discipline can effectively be brought to bear as an important complement to supervisory oversight. In an increasingly complex and integrated global marketplace, the scope and sophistication of disclosures by individual institutions must increase commensurately. If they do not, institutions will find themselves being shut out of markets not by regulators but by their counterparties. Third, prudential supervision in all market economies must be enhanced, and by their history this applies in particular to emerging market economies. This is an area of work that has attracted considerable attention from a wide range of national and international bodies. With emerging market economies growing rapidly, with the close interrelationship between macroeconomic and financial system performance and stability, and with international financial transactions involving these countries becoming increasingly important, it is difficult to exaggerate the importance of sound financial systems in these economies, for their own sake and for the sake of global financial stability. Ultimately, of course, it is the responsibility of those countries themselves to ensure adequate prudential standards. But we all have key roles to play in sharing our experiences and our expertise, and in offering leadership and guidance. Finally, the G-7 leaders felt that the implications of the recent technological advances associated with electronic money should be studied. Central banks have studied many aspects of electronic money. My own sense is that the issues raised are not yet matters that threaten global financial stability. But it is an engrossing area. We should make sure we understand how that technology is developing and what it might mean, while at the same time we allow scope for continued innovation and technical change. Return to top Conclusion To conclude, let me reiterate the basic principle I put forward earlier: Our soundness standards should be no more or no less stringent than those the market place would impose. If banks were unregulated, they would take on any amount of risk they wished, and the market would price their capital and debt accordingly. Ideally, banks should also face regulatory responses to their portfolio risks that simulate market signals. And these signals should be just as tough, but no tougher than market signals in an unregulated world. Perfection would occur if bankers had a genuinely difficult choice deciding if they really wanted their institutions to remain insured or become unregulated. In the final analysis, such an approach is the only way to control the moral hazard of the safety net, to balance stability requirements with risk-taking. An important and increasingly feasible prerequisite in achieving that balance is for the regulators to quantify what their goals are, especially what is meant by soundness. Measuring actual risks relative to these goals would be facilitated if regulators harness for supervisory purposes the market-oriented tools already used internally by banks for management purposes. When seeking to implement this principle and utilize new technologies, we must take care to remember that we are unlikely ever to be able to measure risk in absolutely precise ways. Quantification procedures are still extrapolations of the past, and behavior is always changing. Models will still doubtless be haunted by specification and estimation errors. The global financial marketplace will still remain highly complex, and I have no doubt that participants will continue to invent instruments and procedures that models will not be able to capture until sufficient experience is gained. Thus, I am not proposing nor do I anticipate that bank supervisors will be relying on a black box based on statistical and econometric rules. I am suggesting, however, that new paradigms are in the process of evolving which will provide us with tools that will permit greater quantification of both risk standards and risk management. Such quantification will not solve all of our problems, nor will it ever substitute for human judgment, which ultimately is the technology we must rely on to parse the most difficult problems. Nonetheless, quantification will facilitate great improvements in both risk management and what regulators will be able to do. The financial world is dynamic and I have little doubt that there will be a continuous need to modify what we develop. In the end, judgment must be augmented with technology, and technology must be tempered with judgment. Financial institutions and regulators around the world have a common interest in using evolving new technologies to meet their own separate objectives: maximizing shareholder value and maintaining safe and sound financial systems. One cannot be done without the other. And, as financial institutions increasingly apply these new technologies, supervisors will be replacing their procedures with those that depend increasingly on risk management, risk quantification, market simulations, and within the confines of law reduced barriers. The "best practice" for supervisors is to assure that regulatory restrictions are not a barrier to the "best practices" of the institutions they supervise. If institutions succeed in employing improved risk management and all its tools in order to increase the risk adjusted rate of return, shareholders, the financial system in general, and our economies as a whole, all will be better off.

Japan

https://www.federalreserve.gov/boarddocs/speeches/1996/19961031.htm

The future of electronic payments

Governor Edward W. Kelley, Jr.

At the BAI Money Transfer '96 Conference, New York, New York

The Future of Electronic Payments I am delighted to be with you this morning to discuss the future of electronic payments. This topic is being intensively addressed in the retail banking area, as stored value cards and Internet-based payment systems are introduced to the public, both in the United States and around the world. This morning, however, I want to focus my remarks on the wholesale and correspondent banking markets, where electronic payments already are the norm, but where significant challenges still exist in trying to manage and reduce risks in the payment system. Predicting the future would be folly. However, the enormous amount of creative effort now being invested in addressing settlement risk issues is a very promising sign. I believe it is a time for all of us to push forward aggressively in the wholesale banking area with the arduous work of making changes in the institutional arrangements for clearing and settlement. Let me get right into that theme with a very specific announcement about Fedwire operations. I am pleased to announce that yesterday the Federal Reserve Board approved the date on which the Fedwire funds transfer system will regularly open for business at 12:30 a.m. Eastern Time. That date is Monday, December 8, 1997. Let me repeat. The date is Monday, December 8, 1997. I would like to remind you of several key parts of the early Fedwire program. Most importantly, participation will be voluntary. There is no Federal Reserve requirement that depository institutions must be open to process Fedwires at 12:30 a.m. Participation in the early morning will be determined by the needs of the marketplace. In addition, Federal Reserve daylight overdraft credit will be available during the early morning period, 12:30 a.m. to 8:30 a.m., on the same terms as during the normal operating day. The Board's full daylight overdraft program, including overdraft caps and fees, will be applied in the usual manner. I should note that although daylight overdraft fees will not change, they will be quoted on a basis that reflects the longer Fedwire operating day, beginning in December 1997. Again, this will not represent a change in the actual charge for credit on an hourly basis. The Board will, however, closely monitor the patterns of daylight overdrafts in the early morning period and will review these patterns, along with general developments in the daylight overdraft area, after more experience is gained with the current daylight overdraft fee structure. Dara Hunt, the Product Manager for the Federal Reserve's Wholesale Payments Product Office, will be discussing many of the detailed aspects of early Fedwire funds transfer operations later this morning. Return to top Finally, I should note that the Board has also proposed that the Fedwire securities transfer system be opened earlier in the morning on a voluntary basis. A number of comments have been received on that proposal and we are in the process of analyzing them. As I am sure you know, the Board made the decision to open the Fedwire funds transfer system at 12:30 a.m. back in February 1994 but deferred the implementation date for that decision until late 1997. A major reason for this approach was to allow the banking industry time to prepare for early Fedwire and to implement other technical changes that we have been making to the Fedwire system, such as improved message formats. In retrospect, much has happened in the past few years and I would like to review these developments as an introduction to my main theme that it is "a time for action." The volume of funds being moved has grown rapidly in recent years, risks have grown apace, and much work has been done to move toward meeting the challenges and opportunities these conditions present. Now, the broader context. Statistical reports from the Bank for International Settlements, the International Monetary Fund, and other organizations have continued to document the growth of activity in the international financial markets. Trading volumes have increased dramatically. New instruments and players have arrived on the scene. Settlement flows have continued to grow, even as techniques such as netting have been introduced to reduce both ordinary credit risks and settlement risks. The traditional business of foreign exchange trading, for example, has grown exponentially and generated very large settlement exposures and money flows throughout the international banking system. The estimated turnover in the foreign exchange markets now averages well over one trillion dollars per day, while the flow of funds through Fedwire and CHIPS now averages well over two trillion dollars per day. Risks have escalated in international settlements and these are motivating both commercial and central banks to take action. It is now clear that the settlement process involves more direct credit risk than earlier thought. For example, in the typical foreign exchange settlement, a payment to settle one side of a contract effectively becomes irrevocable one or more days before the payment to settle the other side of the deal is received. Over weekends with holidays there can be four or five calendar days between the beginning and end of the settlement process, which generates very long periods of exposure. Given the enormous flows of funds involved, aggregate exposures for major dealing banks can be very large in proportion to capital. Return to top There is also liquidity risk. If settlement payments are not completed, as scheduled, the cash position of one and possibly a whole group of banks in the major currencies may be adversely affected. To a certain extent, managing so-called "fails" to deliver currencies or securities are part of the international banking business. However, large-scale fails would place significant pressures on the international banking system. Further, there are legal risks. There has been much discussion over the past few years, for example, of the need for strong legal foundations for netting arrangements. Significant progress has been made in a number of countries, including the United States. However, additional progress is essential and we should not assume that the job is complete. There are also operational and security risks. This audience, in particular, is aware of these risks, since operational and security concerns are typically the greatest in the wholesale payments area, where the dollar flow of payments is the largest. However, I would like to note that there has been a lot of public discussion lately of risks in the retail banking area. These discussions have centered, for example, on the use of the Internet or other so-called "open systems" for delivering banking services and making payments. There are important operational and security issues involved in such activities, and I would urge that all banking organizations take these seriously. I might add that these new developments in the retail area may provide significant opportunities to re-examine bank-wide computer information security policies and the strategies for implementing them. A fundamental concern of central banks, of course, is systemic risk. This can involve risks that one bank's problem will spill over onto others, risks that whole clearing systems may cease to operate effectively, and even more broadly, risks that unexpected events will destabilize the banking system as a whole. It is this type of concern that has motivated a sustained effort by the central banking community in a number of areas. In the payment field, concerns about systemic risk have led central banks to call for reductions in settlement risk, in general, and stronger clearing and settlement arrangements, in particular. Over the past ten years a series of reports dealing with the issue of international settlements has been published by the G-10 central banks through the good offices of the BIS. The latest report was issued in March, and was written by the Committee on Payment and Settlement Systems, which is chaired by the President of the Federal Reserve Bank of New York, Bill McDonough. That report clearly called for action to reduce settlement risk in the near term. We should be clear-sighted, however, about the differing roles of central banks and private-sector institutions in pressing forward with efforts to reduce settlement risk. To date, the central banks have provided a solid framework for analyzing risk. Settlement risk has been analyzed in a number of BIS reports, including the Lamfalussy Report on Netting Schemes and the McDonough Report on Settlement Risk in Foreign Exchange Transactions. In addition, risks in securities settlement systems have been extensively analyzed in reports on delivery versus payment and cross-border securities settlement arrangements. Return to top Central banks as a group have strongly suggested that the banking industry move forward with risk reduction and will be monitoring progress toward this goal. Moreover, central banks have recognized the need for flexibility, where possible, in taking steps that will permit the private sector to build more efficient clearing and settlement arrangements that will help reduce settlement risk. One step is the Federal Reserve's decision to open Fedwire at 12:30 a.m., which was conceived in large measure as a means to allow banks and their customers to move money earlier in the day, if they wish, and to synchronize more closely the settlements among different financial markets around the world. Finally, the framework for central bank cooperation in overseeing cross-border and multicurrency clearing arrangements set out in the Lamfalussy Report, along with the general cooperative process involving the Committee on Payment and Settlement Systems, has provided clear points of contact between the G-10 central banks as a group and the developers of various international clearing projects. The Fed is encouraged that the banking industry has become engaged in efforts to analyze and reduce risk. Reports over the past few years on settlement risk, including a major report by the New York Foreign Exchange Committee, as well as new project initiatives for clearing arrangements, have set the stage for real progress. All these efforts have made it clear that the banking industry must maintain, and even increase, its momentum in finding solutions to reduce settlement risk. At the end of the day, it is the international banking industry that is in the best position to understand the details of its own operations and to seek innovative ways to reduce risk. We have already seen some very creative proposals emerge in the past few years, and I have no doubt that there will be more innovative ideas that emerge from the current creative ferment in the international markets. I would like to turn now to some longer term questions posed by the early opening of Fedwire and the broader market developments. First, there is a question of whether established clearing organizations will now take advantage of the earlier Fedwire hours and consider speeding up their money settlement processes. For example, several years ago some in the futures industry urged the Federal Reserve to open the Fedwire earlier in order that interbank funds transfers associated with morning margin settlements may be completed before morning trading begins. Now that a specific date for the early opening of Fedwire has been set, it may be time to consider the timing of these and other money flows once again. Second, there is a question of whether we will see the emergence of early morning money market trading as a result of earlier Fedwire hours and related developments. In particular, will federal funds trading occur in the early morning? Further, if the Fedwire securities transfer system were opened earlier, would trading and money settlements relating to repo and other collateralized transactions occur earlier? It is possible, for example, that if money settlements for both existing and new clearing arrangements were to take place earlier in the morning, money market trading might begin to emerge to accommodate the earlier funding needs of banks and other financial institutions. A closely related issue is the extent to which market participants will look to daylight overdraft credit from the Federal Reserve as an ultimate source for funding early settlements, particularly if formal money market trading does not develop. As I mentioned earlier, these relationships will bear careful watching. Return to top Third, there is a question about whether the conventional settlement times for foreign exchange trades can be shortened, if new institutional arrangements are put in place. Today many currency trades settle on day T + 2, that is, trade date plus two business days. In part, the two days needed for settlement result from activities taking place across different time zones. However, the two days also allow extra time for back office and correspondent banking functions to be completed. New trading arrangements, such as electronic brokerage, along with new clearing arrangements, may well cut short some of these requirements and allow changes in long-standing clearing conventions. Fourth, there is a question about the size of flows through international correspondent banking networks. These flows have grown rapidly with the increase in international banking activity. The role of the dollar in international finance, along with highly efficient U.S. dollar money markets and correspondent banking services, have placed the internationally active correspondent banks that operate in the United States at the center of this growth. Settlement risk reduction, for example through netting, may well reduce the growth or even the level of settlement flows through correspondent banks. Although such possibilities may be difficult for some to accept, they are not necessarily a bad thing. For example, reduced settlement flows might work to bring risks more in line with rewards in some areas. At the same time, of course, reduced settlement flows might also contribute to even greater competitive pressures on the correspondent banking industry than exist today. I would, however, expect the correspondent banking business to adjust to changing conditions by providing new products and services and by continuing to increase efficiency. In this way, the industry will continue to be able to offer key international settlement services in the United States. In conclusion, we must all recognize that the banking environment is characterized by changing players, financial techniques, and technologies. In addition, the sheer volume of cross-border activity has increased, to the point where many markets and their clearing systems have become inherently international in scope. Our response should be that innovation, along with international trade in financial services, is a good thing and that there is every reason to encourage change. At the same time, prudent management is essential, in order for innovation and global markets to benefit the wider economy. In the payments field, there is much work yet to do to ensure that strong foundations are laid under the expanding international financial markets. The blueprints and initial projects show promise. But I also believe that there will be very hard and detailed work yet to come. I urge all of you to stay with this job and see it through to the end.

New York

https://www.federalreserve.gov/boarddocs/speeches/1996/19961024.htm

Accounting and auditing standards and bank supervision

Governor Susan M. Phillips

"At the 23rd Annual Accounting Lecture Series of the University of Tennessee, Chattanooga, Tennessee(...TRUNCATED)

" It is a pleasure to join you today for the 23rd Annual Accounting Lecture Series at the University(...TRUNCATED)

Tennessee

https://www.federalreserve.gov/boarddocs/speeches/1996/19961016.htm

Technological advances and productivity

Chairman Alan Greenspan

At the 80th Anniversary Awards Dinner of The Conference Board, New York, New York

"Remarks by Chairman Alan Greenspan Technological advances and productivity At the 80th Anniversary (...TRUNCATED)

New York